By Cliff Montgomery – Jan. 22nd, 2010
Today the House Committee on Financial Services held a full committee hearing on the Performance andIncentives of America’s Financial Sector. Perhaps the most engaging testimony was delivered by topeconomist Joseph Stiglitz, a Columbia University Professor who teaches in the Department of Economics, theGraduate School of Business, and the School of International and Public Affairs.
We at the American Spark consider Stiglitz to be one of this country’s most brilliant and insightfuleconomists. And it’s clear others agree with us.
According to the biographical information accompanying Stiglitz’ printed testimony, he “formerly served asChairman of the Council of Economic Advisers (1995-1997) and as Chief Economist and Senior VicePresident of the World Bank (1997-2000). He was awarded the Nobel Memorial Prize in Economics in 2001and was a lead author of the Intergovernmental Panel on Climate Change (IPCC) Report of 1995. The IPCC shared the Nobel Peace Prize [with Stiglitz] in 2007.”
Below we provide a major section of Stiglitz’ eye-opening testimony:
“It is both a source of pleasure and sadness to testify before you today—I welcome this opportunity to testifyon this important subject, but at the same time, it is a source of sadness that you should have to hold hearingson this matter, more than two years after the onset of the Great Recession of 2008.
“In this brief testimony, I can only touch on a few key points. Many of these points I elaborate in my bookFreefall, which was published just a few days ago.
“Our financial system failed to perform the key roles that it is supposed to perform for our society: managingrisk and allocating capital. A good financial system performs these functions at low transaction costs. Ourfinancial system created risk and mismanaged capital, all the while generating huge transaction costs, as thesector garnered some 40% of all of corporate profits in the years before the crisis.
“The sector is also responsible for running the payments mechanism, without which our economy cannotfunction. But so badly did it manage risk and misallocate capital that our payments mechanism was in dangerof collapse. So deceptive were the systems of creative accounting that the banks had employed that, as thecrisis evolved, they didn’t even know their own balance sheets, and so they knew that they couldn’t know thatof any other bank.
“No wonder then that no bank could trust another, and no one could trust our banks. No wonder then that oursystem of credit—the lifeblood on which the economy depends—froze.
“We may congratulate ourselves that we have managed to pull back from the brink, but we should not forgetthat it was the financial sector that brought us to the brink of disaster.
“I should qualify these remarks, and much of what I shall say later, by a general caveat: parts of our financialsystem have done an excellent job.”
“America’s venture-capital firms help provide finance to some of America’s innovative firms and play animportant role in the economy’s long-term success. But these firms are a small part of the financial industry.
“Money that went into housing that buyers could not afford could have been used to finance new investmentthat would have increased the long-run productivity of our economy. Resources are scarce, and our financialsector misallocated these scarce resources on a massive scale. The crisis has reportedly forced venture-capital firms to cut back investment – these dynamic parts of America’s economy will be forced to pay a highprice for others’ mistakes.
“While the failures of the financial system that led the economy to the brink of ruin are, by now, obvious, thefailings of our financial system are more pervasive. Small-and medium-sized enterprises found it difficult to getcredit, even as the financial system was pushing credit [i.e., debt] on poor people beyond their ability to repay.Modern technology allows for the creation of an efficient, low-cost electronic payment mechanism – butbusinesses pay 1 to 2 per cent or more in fees for a transaction that should cost pennies or less.
“Our financial markets not only mismanaged risk—and created products that increased the risk faced byothers—but they also failed to create financial products that would help ordinary Americans face the importantrisks that they confronted, such as the risks of home ownership or the risks of inflation.
“Indeed, I am in total agreement with Paul Volcker—it is hard to find evidence of any real growth associatedwith the so-called innovations of our financial system, though it is easy to see the link between thoseinnovations and the disaster that confronted our economy.
“Underlying all of these failures is a simple point, which seems to have been forgotten: financial markets are ameans to an end, not an end in themselves. If they allocate capital and manage risk well, then the economyprospers, and it is appropriate that they should garner for themselves some fraction of the resulting increasesin productivity.
“But it is clear that pay was not connected with social returns—or even long-run profitability of the sector. Formany financial institutions, losses after the crisis were greater than the cumulative profits in the four yearspreceding the crisis. From a longer-term perspective, profits were negative.
“Yet the executives walked off withample rewards, sometimes in the millions. Most galling for many Americans was the fact that even when profitswere negative, many financial institutions proposed paying large bonuses.
“We should remember this is not the first time that our banks have been bailed out, saved from bearing theconsequences of their bad lending. While this is only the second major bailout in twenty years in the US, pastresponses to financial crises abroad – in Mexico, Brazil, Russia, Indonesia, Thailand, Argentina, and manyothers – were really bailouts of American and European banks, at the expense of taxpayers in these countries,engineered through the bankers’ allies at the IMF and the US Treasury.
“In each of these instances, the banks had made bad lending decisions, lending beyond the ability orwillingness of borrowers to repay.
“Market economies work to produce growth and efficiency, but only when private rewards and social returnsare aligned. Unfortunately, in the financial sector, both individual and institutional incentives were misaligned.
“The consequences of the failures of the financial system were not borne just by those in the sector but byhomeowners, retirees, workers, and taxpayers, and not just in this country but also around the world.
“The ‘externalities,’ as economists refer to these impacts on others, were massive. There were huge privateprofits in the short run, in the years before the crisis, offset by the even larger losses during the crisis. But thebanks and the bankers reaped the benefits of the former without paying proportionately for the costs of thelatter.
“Alan Greenspan, in his famous mea culpa, explained his misguided confidence in self-regulation—he hadassumed that bankers would do a better job in managing risk, in doing what was in their own interests. Eventhis diagnosis was flawed: he was right about the failure to manage risk, but it was not so obvious that whatthey did was not in their own interests.
“But all of this misses the real reason for regulation. If I gamble in Las Vegas and lose, only I (and my family)suffer. But in America’s casino capitalism, when the banks gambled and lost, the entire nation paid the price.We need regulation because of these externalities.
“So far, I have made four key points:
1. Banks have consistently failed to fulfill their basic societal mission.
2. Banks have repeatedly been bailed out from bearing the consequences of their flawed lending.
3. Incentives within the financial system are distorted at both the individual and institutional level—at both levelsprivate rewards and social returns are misaligned.
4. The financial sector has imposed large costs on the rest of society—the presence of externalities is one ofthe reasons why the sector needs to be regulated.
“In previous testimony, I have explained what kinds of regulations are required to reduce the risk of adverseexternalities. I have also explained the danger of excessive risk taking and how that can be curtailed. I haveexplained the dangers posed by under-regulated derivative markets (including credit default swaps).
“I regret to say that so far, more than a year after the crisis peaked, too little has been done on either account.”
