More From The Bull That Brought Us To The Brink?
The Age
Wednesday October 1, 2008
The problems in the US financial system have been apparent for years, writes Joseph Stiglitz.
IT DOESN'T take a genius to see that the US financial system - indeed, global finance - is in a mess. And now the US House of Representatives has rejected the Bush Administration's proposed $US700 billion($A840 billion) bail-out plan,it is also obvious there is no consensus on how to fix it.The problems in the US economy and financial system have been apparent for years. But that didn't prevent America's leaders from turning to the same people who helped create the mess, who didn't see the problems until they brought us to the brink of another Great Depression,and who have been veering from one bail-out to another, to rescue us.As global markets plummet, the rescue plan will almost certainly be put to another vote in Congress. It may rescue Wall Street, but what about the economy? What about taxpayers, already hit by unprecedented deficits, and with bills to pay for decaying infrastructure and two wars?In such circumstances, can any bail-out plan work?To be sure, the rescue plan that was just defeated was far better than what the Administration originally proposed. But its basic approach remained critically flawed. First, it relied - once again - on trickle-down economics: somehow, money thrown at Wall Street would reach Main Street, helping ordinary workers and home owners. Trickle-down economics almost never works, and is no more likely to work this time.Moreover, the plan assumed that the fundamental problem was one of confidence. That is no doubt part of the problem; but the underlying problem is that financial markets made some very bad loans. There was a housing bubble, and loans were made on the basis of inflated prices.That bubble has burst. House prices probably will fall further, so there will be more foreclosures, and no amount of talking up the market will change that. The bad loans, in turn, have created big holes in banks' balance sheets, which have to be repaired. Any government bail-out that pays fair value for these assets will do nothing to repair that hole. On the contrary, it would be like providing massive blood transfusions to a patient suffering from vast internal hemorrhaging.Even if a bail-out plan is implemented quickly - which looks increasingly unlikely - there will be some contraction in credit. The US economy has been sustained by a consumption boom fuelled by excessive borrowing, and that will be curtailed. States and localities are cutting back expenditures. Household balance sheets are weaker. An economic slowdown will exacerbate all our financial problems.We could do more with less money. The holes in financial institutions' balance sheets should be filled in a transparent way. The Scandinavian countries showed the way two decades ago. Warren Buffett showed another way, in providing equity to Goldman Sachs. By issuing preferred shares with warrants (options), one reduces the public's downside risk and ensures that they participate in some of the upside potential.This approach is proven and provides both the incentives and wherewithal needed for lending to resume. It avoids the hopeless task of trying to value millions of complex mortgages and the even more complex financial products in which they are embedded, and it deals with the "lemons" problem - government getting stuck with the worst or most overpriced assets. Finally, it can be done far more quickly.At the same time, several steps can be taken to reduce foreclosures. First, housing can be made more affordable for poor and middle-income Americans by converting the mortgage deduction into a cashable tax credit. The Government effectively pays 50% of the mortgage interest and real estate taxes for upper-income Americans, yet does nothing for the poor. Second, bankruptcy reform is needed to allow home owners to write down the value of their homes and stay in their houses. Third, the Government could assume part of a mortgage, taking advantage of its lower borrowing costs.By contrast, US Treasury Secretary Henry Paulson's approach is another example of the kind of shell games that got America into its mess. Investment banks and credit rating agencies believed in financial alchemy - the notion that value could be created by slicing and dicing securities. The new view is that real value can be created by un-slicing and un-dicing - pulling these assets out of the financial system and turning them over to the Government. But that requires overpaying for the assets, benefiting only the banks.If such a plan is adopted, American taxpayers will probably be left on the hook. In environmental economics, there is a basic principle called "the polluter pays". It is a matter of both equity and efficiency. Wall Street has polluted the economy with toxic mortgages. It should pay for the clean-up.Economists are coming to a consensus that any bail-out based on Paulson's plan won't work. The danger is the huge increase in the national debt and the realisation that even $US700 billion is not enough to rescue the US economy will erode confidence further and aggravate its weakness.But it is impossible for politicians to do nothing in such a crisis. So, pray that an agreement crafted with the toxic mix of special interests, misguided economics, and right-wing ideologies that produced the crisis can somehow produce a rescue plan that works - or whose failure doesn't do too much damage.Getting things right - including a new regulatory system that reduces the likelihood that such a crisis will recur - is one of the many tasks to be left to the next administration.Joseph Stiglitz is a professor of economics at Columbia University and recipient of the 2001 Nobel Prize in economics. He is co-author, with Linda Bilmes, of The Three Trillion Dollar War: The True Costs of the Iraq Conflict.
© 2008 The Age