Debate with the audience

par Joseph E. Stiglitz, Marshall Auerbach, Marcellus Andrews

Question from the audience

I have two remarks. The first one is about hidden problems: we knew all the time there were problems when you over-leverage things and make loans. It didn’t come as a surprise. But the real question is how to get a new international payment system, which I think is the point. We cannot do anything in the United States until we solve that problem. The second one is about regulation. The problem will be as follows: Robert Rubin, Alan Greenspan and others will say: “if you put regulation on United States financial institutions, they will just go somewhere else. People will work through the Swiss banking system, since it’s so easy to move your money around the world. So, you cannot regulate at all unless you regulate globally, which is not likely to occur, certainly not in Switzerland anyhow”. What is needed is some form of capital flow constraints until we handle the international problem. We no longer can have a currency hegemony system. We have to have some sort of international payment system that doesn’t rely on the dollar. That’s going to be the hard part.

 

Joseph Stiglitz

First, I think that the concern you have raised is one that has been weighing on the minds of people like Barney Frank1, who are trying to redesign the financial system; and it’s one of the ways in which people try to scare away regulation. There is some evidence that countries that have good financial markets, including sound regulation, will actually do better than those that are more volatile because they have weak financial regulation. That’s the first point. I’m not sure that it’s that bad, that it is necessarily a race to the bottom. Though I do know that many of the G-7 members are worried about trying to coordinate our efforts to get a global regulatory system. The second point is that we can do a lot in what I call ring fencing. That is to say, “I don’t care if people go and gamble in Las Vegas, and I don’t care if they go gamble in the Cayman Islands; I just care if they gamble in ways that affect me”. The question is, can we make sure that our financial system isn’t touched by gambling going on elsewhere? And I think the answer is yes, provided we impose one simple rule: that no American bank can engage in any transaction with a bank from any country that does not subscribe to the common standards. And that will end the Cayman Islands, or at least induce it to improve. The issue isn’t whether we can do it; it’s really the political economy issue that was being raised. Someone who had been working at Lehman Brothers told me that when he got hired, they opened up an account for him in the Cayman Islands, as part of the welcome package. That’s part of the framework. And these loopholes are not there by accident. But I think we have turned a corner, that we may be able to use this occasion for doing something about it. Two other points, very briefly. The nature of our current problems has long been anticipated. There are no surprises here except for those who wanted to be surprised. I just reread one of the papers I wrote in 1990, at the beginning of the securitization process. I actually predicted what would happen, I even went down to predict the details, like that hey were going to underestimate the degree of the correlation and underestimate the probability that the prices would fall.

 

Question from the audience

There were some stories recently in the press about how retail sales collapsed in October. But there was one exception to that, which was that Wal-Mart sales went up. Now in the short run that can be interpreted as people moving down-market because their incomes are tight. But I think it also indicates a longer-run problem: Wal-Mart is successful not just because they import from China or have supply-chain management, but because the demand for their products grow as incomes stagnate. We all know median income in real terms has been roughly stagnant, which of course is one reason why debt has expanded: people were trying to maintain living standards. I wonder whether this isn’t part of the long-term problem that we’re discussing, and part of the long-term structural solution. To give you one example: I went back and looked at, for example, flow of funds data right after the 2003 tax cut. As you know, flow of funds indicates where asset purchases and sales are going. And there was a sharp increase in the personal purchases of foreign assets, foreign financial assets, which suggested that the people receiving the tax cut used the money to buy foreign financial assets, that they moved the money out of the country. So I think what we are getting is a real imbalance, where the driving force of consumer demand has moved down-market, while the upper part of the income distribution, which is supposed to generate the savings, according to the trickle-down theory, has actually been buying assets all over the world. How much of that comes back, we don’t know; but it does suggest a structural problem which was at least hinted at in the campaign because of Obama’s notion of raising taxes on the upper income and lowering it for others. The other issue we need to raise, given that Economists for Peace and Security are co-organizers of this conference, is the military budget, which in real terms is higher than it has been at any point since World War II. And although it’s not quite as high in terms of its share in the economy, there’s going to be pressure to keep pushing it up. There’s no indication from the Obama staff about where they would stand on this or whether they would even address issues about all theinefficiencies, which are absolutely immense, within the National Security apparatus. Usually people talk about, well, non-military government spending, which is primarily health, education, and infrastructure, which is exactly what we need, both to deal with some of the causes of inequality, but also because economic growth is increasingly dependent on human capital, knowledge, and infrastructure.

 

Marcellus Andrews

I agree with your interpretation of the shift in consumption spending towards Wal-Mart; but this brings up another interesting issue. I have come to the view that part of our long-term problem is not just inequality but also declining incomes for people in the bottom 60 or even maybe 70 percent of the income distribution scale: declining real incomes and rising costs for education, health care, and so forth. These problems were managed to some degree by the debtbased social contract pioneered by those who gave us supply-side economics. The popping of that bubble is consistent with the economic collapse we seem to be facing, and that is made worse by the recklessness in the financial markets. The political challenge we face while trying to reconstruct the social contract along the lines that you mentioned is that there’s going to be a fight over the use of public resources: should we or should we not have high levels of social infrastructure expenditure and public consumption? This is not just a question of regulation, but of power, of whether certain sectors of the systemhave a voice in the restructuring of the social contract. I hear a certain fear about the abandonment of the American social contract in an age where capital is global. Unless we confront the political challenge, we won’t be able to do the things we need to do.

 

Joseph Stiglitz

Two comments, both somewhat theoretical. The first is that the point that several people have raised about the change in the distribution of income towards upper income and away from lower income is related to in a way, an old argument that goes back to pre-World War II discussions. There was a worry, as we emerged from World War I, that there would not be sufficient aggregate demand. There was a theory of under-consumption. According to modern economic theories like the theory of adjustment, we don’t have to worry about that; the economy always gravitates to full employment. Keynes’s view, of course, was very clear: this might happen, but it would happen too slowly and not necessarily in a stable way. And I think that this really is something that ought to be given some attention. What are the processes of adjustment, where do they take us, and why are they unstable? If we don’t address the underlying inequalities, which is another way of trying to get up consumption, where will the current system lead us? Because there will be some adjustment, but the question is: which one? The second comment is an idea that one of my colleagues, Bruce Greenwald, has suggested. I just throw it out, because I haven’t yet figured out the extent to which I agree with it; though I think it is an interesting idea. Greenwald suggested that the Great Depression was a defining moment where we realized that the U.S. was no longer an agricultural economy, that it was a part of the structural adjustment. Today,we have a very prosperous agricultural sector, but it only employs 2 to 3 percent of our work force, because we had an enormous productivity increase. So it’s both an achievement and a problem. Manufacturing was the base of our economy for the last 75 years and we have had enormous success in our manufacturing sector, enormous productivity increases. Then the globalization transmitted a lot of this know-how around the world. Now if you take that view, it suggests that America, together with other advanced industrial countries, may be going through a wrenching adjustment. The adjustment meaning that manufacturing is no longer our competitive comparative advantage and will not absorb as many jobs is it did in the past, and that we’ll be able to have all the television sets in the world that we want – one in every room, one in every closet – and that providing all these goods to most of the people in the world will still not employ very many people, just like providing all the food will not employ very many people. Now, if that’s true, obviously some adjustment is going to be entailed in our economy – in America in particular, but also in the global economy – and if that’s true, then we ought to be thinking about, as we look for short-term responses to the crisis, how our spending can help us to make the transition to the new economy. This is what the debate we didn’t mention so far, about the bailout of the automobile industry, is about. It is an attempt to preserve the old economy, an old economy whose CEOs have proven their incompetence. And now we want to maintain them. Or is there another way of facilitating the transition, making them a different kind of manufacturing, green economy, and so forth? I just raise that as an idea that I’m not sure how to evaluate, but I think it is an interesting perspective.

 

Question from the audience

If you accept the Federal Reserve data – and I don’t know who else’s to use – the U.S. financial sector had $63 trillion in assets and $4.5 trillion of equity capital at the beginning of the year. Let’s say we’re down to about $55 trillion in assets and $1.5 trillion in equity capital right now. If we went back to 1997 capital ratios, which probably were too aggressive, it would imply that the U.S. financial system needs somewhere between $6 and $7 trillion of new equity capital. It makes the $250 billion first tranche of TARP look like a really bad joke. It can’t do anything. But $5, 6, 7 trillion to recapitalize existing balance sheets, that’s 50 percent of our GDP. I guess the only way out of this is a whole-scale nationalization of financial systems. How do we manage that? How on earth do we manage shrinking this balance sheet that there’s no way we can support?

 

Question from the audience

There is of course an immediate challenge before us, but what if the stage that we have entered, the financialization stage, is actually a third stage of our history, moving our economy from manufacturing to finance capital? And if the finance capital now also is finished, what should we expect next?

 

Marcellus Andrews

What next? Well, to take Professor Stiglitz’s discussion of the automobile industry and why it may not be a very good idea to save that particular company, or to save the CEO’s, we have to figure out what to do with workers and regions concerned by this. Some of my colleagues spent a lot of time wondering how the United States can take advantage of the so-called green economy. The economists need to figure out a way to turn our country into a place that generates clean technologies, clean ways of living, clean ways of moving, not simply for ourselves, but for the rest of the world. We must pioneer a form of progressive, green capitalism that makes the proper use of markets, that figures out how to price carbon, how to dispose of it, how to deal with the difficult question of coal. Gradually, we have to develop the technologies and the ways of life that we then export to the rest of the world. This would require a redefinition of the role of the state, a redefinition of the nature of the mixed economy, and a fight over who ultimately owns the state.

 

Joseph Stiglitz

Let me answer the first question. We have a certain amount of assets in our society. We have human capital, physical capital, land – all that’s here. It hasn’t been destroyed – a little of it has, but most of it has not been destroyed. All you’re talking about are claims on those assets. And our system of claims on assets has gotten a little jumbled up. People were betting large amounts of money, so much that A owed B, B owed C, but B can’t pay C because A can’t pay B. And one way of thinking about this crisis is this: everybody was gambling with other people’s money, and our whole system of claims on these assets has gotten jumbled up. So, what we need to do is straighten it out. And that’s what bankruptcy is about. It doesn’t destroy the assets. The car company is still there, the machines are there. It’s important, because who controls the claims not only determines future income, but also determines decisions. If you allow the same guys who made the bad decisions to still be in the place of making the decisions, they’ll make probably the same bad decisions. And going back to the automobile company, these guys are the guys who said, “I don’t want to think about global warming, I don’t want to think about making energy-efficient cars”. Every time anybody proposed a regulation, they went to their lawyers to try to stop it. So why should we trust these guys to go into a green economy? That’s not where their heart is. That’s why there has to be change in management of a massive kind. Going forward, to keep an economy going, you have to have credit. Credit is basically claims on future resources.

« No American bank can engage any transaction with a bank from a country that does not subscribe to the common standards. »

The banks are just a vehicle for certifying credit worthiness. Who should I give assets to today in exchange of a promise to pay back in the future? Our investment banks have shown that they are not capable of making those judgments. So again, my view is just, get rid of them. I’m being a little bit extreme, but what I want to do is to raise the conceptual issue, and the issue is that there are some people, some regional banks that have done not too badly. They were caught up and made some judgment mistakes. So it’s trying to recreate a system of credit flow which is necessary in order to maintain the production flow and to straighten out the whole set of complicated claims – when you talk about trillions, people say there are trillions of dollars of CDO’s (collateralized debt obligation), well beyond the global GDP. What are those? Those are just massive gambles. How do you make the massive gambles? People owe you trillions, so you can owe other people trillions. And that whole system of massive gambling on other people’s money has fallen apart. I don’t think it’s a big deal.

 

Question from the audience

Private assessment of risk, credit worthiness of individuals and firms, all this has been badly shaken up. And there have been several reform proposals recently, for instance to reform the credit rating agencies and create a centralized agency that would be quasi-independent. I would like to know what the panel thinks about that. Question from the audience There’s a lot of talk about stimulus, big stimulus, but very little about where we should spend this money and where we shouldn’t spend it, or how we should raise it and how we shouldn’t. Surely, military spending is the absolutely worst kind of spending, we should rather spend on human capital. But let’s look more closely at what we should and shouldn’t spend, because just any “old” spending could be terrible.

 

Marshall Auerbach

I agree with that last question. Beyond obvious things like extending unemployment claims and food stamps, I do believe in the general thrust of “green” infrastructure, and generally public infrastructure in general. You have bridges falling apart in Minnesota. That in itself should be a clear indication of what we should be doing. And I would also substantially cut military expenditure and transfer the funds to something else. Unfortunately, the Pentagon has such a powerful influence on U.S. politics that I wonder if there will be a serious cut in military expenditures. But obviously we need that. The U.S. spends more on its defense than the next 20 countries combined. As for the rating agencies, today we have market-based agencies rating the products of their customers. This leads to conflicts of interest that would be best eliminated by having third-party independent agencies. But I have also been wondering about securitization as a whole. My wife is a theoretical physicist, and when I described what securitization was, she said: “you used the techniques of statistical mechanics to treat asset prices like subatomic particles. Now the thing is, there are a lot of subatomic particles. They all move around more or less on their own. Now you’re treating these things like asset prices in people’s portfolios, but all these people think more or less the same way, so even if they never talk to each other, the asset prices are automatically correlated”. When you think about it: we’ve got all kinds of financial instruments that come from using even more esoteric techniques in mathematics, but wouldn’t it behoove somebody to actually do the math first, before going out and selling it? You would think that the people who came up with these instruments would at least try it out first, wouldn’t you?

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