Wednesday, September 22, 2010

Freefall by Joseph E. Stiglitz

It is said that a near death experience forces one to reevaluate priorities and values. The global economy has just had a near-death experience. The crisis not only exposed the flaws in the prevailing economic model but also flaws in our society. Too many people have taken advantage of others. A sense of trust had been broken. Almost every day has brought stories of bad behavior by those in the financial sector – Ponzi schemes, insider trading, predatory lending, and a host of credit card schemes to extract as much from the hapless user as possible. This book has focused, though, not on those who broke the law, but the legions of those who, within the law, had originated, packaged and repackaged, and sold toxic products and engaged in such reckless behavior that thy threatened to bring down the entire financial and economic system. The system was saved, but at a cost that is still hard to believe.

We should take this moment as one of reckoning and reflection, of thinking about what kind of society we would like to have, and ask ourselves, Are we creating an economy that is helping us achieve those aspirations? We have gone far down a path to creating a society in which materialism dominates moral commitment, in which the rapid growth that we have achieved is not sustainable environmentally or socially, in which we do not act together as a community to address our common needs, partly because rugged individualism and market fundamentalism have eroded that sense of community and have led to rampant exploitation of unwary and unprotected individuals and to an increasing social divide.…

Much has been written about the foolishness of the risks that the financial sector undertook, the devastation that the financial institutions have brought to the economy, and the fiscal deficits that have resulted; too little has been written about the underlying 'moral deficit' that has been exposed – a deficit that may be larger and even harder to correct. The unrelenting pursuit of profits and the elevation of the pursuit of self-interest may not have created the prosperity that was hoped, but they did create the moral deficit.

There was perhaps a fine line between creative accounting and deceptive accounting – a fine line that the financial sector has crossed time and time again, including a few short years ago, in the WorldCom and Enron scandals. It is not always possible to distinguish between incompetence and deception, but it is not likely that a firm claiming to have a net worth of more than a hundred billion dollars would suddenly find itself in negative territory without knowing that its accounting was deceptive. It is not believable that the mortgage originators and the investment bankers didn't know that the products they were creating, purchasing, and repackaging were toxic and poisonous. The investment bankers would like us to believe that they were deceived by those that sold the mortgages to them. But they were not. They encouraged the mortgage originators to go into the risky subprime market because it was only through the ample supply of mortgages and the transformation of risky assets into new products that they earned the fees and generated the returns that, through leverage, made them look like financial wizards. If they were deceived, it was because they didn't want to know. It is possible that a few didn't know what they were doing, but they are also guilty then, of a different crime, that of misrepresentation, claiming that they knew about risk when clearly they did not.

Exaggerating the virtue of one's wares or claiming greater competency than the evidence warrants is something we might have expected from many businesses, though the extent was surely out-sized, just as were the egos and the pay. But harder to forgive is the moral depravity – the financial sector's exploitation of the poor and even middle-class Americans. Financial institutions discovered that there was money at the bottom of the pyramid and did everything within the law ( and many went beyond the law) to move it towards the top. What happened to the moral compunctions of those engaging in these practices?

Bernie Madoff's Ponzi scheme was not all that different from the schemes of others who undertook high leverage. The financiers knew that the high returns in the short run (with concomitantly high fees) would likely be followed by large losses, which under their contracts would not affect their bonuses. These devotees of perfect markets should have known that leverage can't deliver a free lunch – out-sized returns with no out-sized downside risks.

No matter how you look at it, our banks and our bankers, both before and during the crisis, did not live up to the moral standards that we should hope for, especially in their exploitation of ordinary borrowers. The subprime mortgages are just another example of a long litany of abusive practices in a variety of venues, which include student loans, pay day loans, rent-a-centers, credit and debit cards.

Those who are suggesting that they are free to operate as they like, so long as they remain within the law, are attempting to get by too easily. After all, the business community spends large amounts of money trying to get legislation that allows it to engage in these nefarious practices. The financial industry worked hard to stop legislation to prevent predatory lending, to gut consumer protection laws, and to ensure that the federal government – with its lax standards – overrode state regulators. Worse, many corporations have tried hard to get legislation to protect them from ordinary liability. The dream of the tobacco companies is to have the kind of 'light' regulation that doesn't prevent them from doing anything that they would otherwise do, but allows them to say, in defense of any deaths that result from their activity, that they assumed that everything they did was okay – because it was all legal and done with complete oversight of the government.

A naïve reading of Adam Smith might have suggested that he had relieved market participants from having to think about issues of morality. After all, if the pursuit of self-interest leads, as if by an invisible hand, to societal well-being, all that one has to do – and all that one should do – is to be sure to follow one's self interest. And those in the financial sector seemingly did that, even claiming that it was their obligation to shareholders. But clearly, the pursuit of self-interest did not lead to shareholder or societal well-being, either in this episode or in the earlier scandals involving WorldCom and Enron.

The swash-buckling model of rugged individualism, epitomized so strongly by President Bush with his cowboy boots and manly swagger, pictures a world in which we are responsible for our own successes and failures – and we reap the rewards of our efforts. But these are myths. “No man is an island” What we do has large effects on others; and we are what we are at least partly because of the efforts of others. Much of the talk about accountability too seems just a matter of words: In Japanese society, A CEO who was responsible for destroying his firm, forcing thousands of workers to be laid off, might commit hari-kari. In the United Kingdom, CEOs resigned when their firms failed. In the United State, they are fighting over the size of their bonuses.

In today's financial markets, almost everyone claims innocence. They were all just doing their jobs. And so they were. But their jobs often entailed exploiting others or living off the results of such exploitation. There was individualism but no individual responsibility. In the long run, society cannot function well if people do not take responsibility for the consequences of their actions. “I was just doing my job” cannot be a defense. There is meaning to individual and corporate responsibility. Firms need to do more than just maximize their market value, think more about what they do and the impacts on others. They cannot get by by saying that they are 'just” maximizing their incomes...

In a performance-orientated society such as ours, we strive to do well – but what we do is affected by what we measure. Politicians, policymakers and economists all strive to understand what causes better performance as measured by GDP. But if GDP is a bad measure of societal well-being, then we are striving to achieve the wrong objective. Indeed, what we do may be counterproductive in terms of our true objectives.

The measure GDP in the U.S. didn't really give a good picture of what was going on before the housing bubble burst. America thought it was doing better than it was, and so did others. Economists did sophisticated studies relating success to different policies – but because their measure was flawed, the inferences they drew from the studies were flawed. The crisis then showed how badly distorted market prices can be – with the result that our measure of performance is badly distorted. Even without the crisis, the prices of all goods are distorted because we have treated our atmosphere as if it were free, when in fact it is scarce.

Our economic growth has been based too on borrowing from the future: we have been living beyond our means. So too, some of the growth has been based on the depletion of natural resources and the degradation of the environment- a kind of borrowing from the future, more invidious because the debts we owe are not so obvious. We are leaving future generations poorer as a result, but our GDP indicator doesn't reflect this.

GDP per capita measures what we spend on health care, not the output – the status of our health reflected, for instance, in life expectancy. The result is that as our health care system gets more inefficient, GDP may appear to increase, even though health outcomes become worse.

Another example of the misleading nature of the standard measure, average GDP per capita can being going up even when most individuals in our society not only feel they are worse off, but actually are worse off. This happens when societies become more unequal. A larger pie doesn't mean that everyone – or even most people – gets a larger slice. In the U.S., by 2008, the median household income was some 4 percent lower than it was in 2000, adjusted for inflation, even though GDP per capita had increased by 10 percent.

Most Americans standards of living, their sense of well being, have declined more than the national incomes might suggest. They feel less secure about their job, knowing that if they lose their job they will also lose their health insurance. With soaring tuition costs, they feel less secure that they will be able to provide their children with an education that will fulfill their aspirations. With retirement accounts diminished, they feel less secure that they will spend their old age in comfort, or keep their homes. For many Americans, life is on a precipice [ and this is not well reflected when we pass an official GDP benchmark that says 'the recession is over'.]

There are many other values that are not captured in our standard measure of GDP: we value leisure, whether we use it for relaxation, for time with the family, for culture, or for sports. Leisure can be particularly important for the millions whose jobs provide limited immediate satisfaction, for those who work to live rather than who live to work. But America, as a whole, has not enjoyed the greater leisure economist predicted by increases in productivity or GDP growth. The number of hours worked per household has actually gone up by 26 percent over the last thirty years. We have become a consumer/materialistic society: two cars in every garage, iPods in every ear, and clothes without limit. We buy and dispose. Europe took a very different tack. A five-week vacation is the norm – Europeans shutter at our two week standard. France's output per hour is higher than than that in the United States, but the typical Frenchman works fewer hours and so has a lower income.

We may not be able to say which lifestyle is better. But the U.S. lifestyle is not sustainable. Others may be more so. If those in the developing countries try to imitate America's lifestyle, the planet is doomed. There are not enough natural resources, and the impact on global warming would be intolerable. America will have to change – and it will have to change quickly.

It has become a cliché to observe that the Chinese characters for crisis reflect “danger” and “opportunity”. We have seem the danger. The question is, Will we seize the opportunity to restore our sense of balance between the market and the state, between individualism and the community, between man and nature, between means and ends? We now have the opportunity to create a financial system that will do what human beings need a financial system to do: build an economic system that will create meaningful jobs, decent work for all those who want it, one in which the divide between the haves and have-nots is narrowing, rather than widening; and most importantly of all, to create a new society in which each individual is able to fulfill his aspirations and live up to his potential, in which we have created citizens who live up to shared ideals and values [ or that those values at least be reciprocal and mutually predictable], in which we have created a community that treats our planet with the respect that in the long run it will surely demand. These are the opportunities. The real danger now is that we will not seize them.

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