Reversal of Fortune
Describing how ideology, special-interest pressure, populist politics, and sheer incompetence have left the U.S. economy on life support, the author puts forth a clear, commonsense plan to reverse the Bush-era follies and regain America’s economic sanity.
by Joseph E. Stiglitz November 2008
When the American economy enters a downturn, you often hear the experts debating whether it is likely to be V-shaped (short and sharp) or U-shaped (longer but milder). Today, the American economy may be entering a downturn that is best described as L-shaped. It is in a very low place indeed, and likely to remain there for some time to come.
Virtually all the indicators look grim. Inflation is running at an annual rate of nearly 6 percent, its highest level in 17 years. Unemployment stands at 6 percent; there has been no net job growth in the private sector for almost a year. Housing prices have fallen faster than at any time in memory—in Florida and California, by 30 percent or more. Banks are reporting record losses, only months after their executives walked off with record bonuses as their reward. President Bush inherited a $128 billion budget surplus from Bill Clinton; this year the federal government announced the second-largest budget deficit ever reported. During the eight years of the Bush administration, the national debt has increased by more than 65 percent, to nearly $10 trillion (to which the debts of Freddie Mac and Fannie Mae should now be added, according to the Congressional Budget Office). Meanwhile, we are saddled with the cost of two wars. The price tag for the one in Iraq alone will, by my estimate, ultimately exceed $3 trillion.
This tangled knot of problems will be difficult to unravel. Standard prescriptions call for raising interest rates when confronted with inflation, just as standard prescriptions call for lowering interest rates when confronted with an economic downturn. How do you do both at the same time? Not in the way that some politicians have proposed. With gasoline prices at all-time highs, John McCain has called for a rollback of gas taxes. But that would lead to more gas consumption, raise the price of gas further, increase our dependence on foreign oil, and expand our already massive trade deficit. The expanding deficit would in turn force the U.S. to continue borrowing gargantuan sums from abroad, making us even more indebted. At the same time, the higher imports of oil and petroleum-based products would lead to a weaker dollar, fueling inflationary pressures.
Millions of Americans are losing their homes. (Already, some 3.6 million have done so since the subprime-mortgage crisis began.) This social catastrophe has severe economic effects. The banks and other financial institutions that own these mortgages face stunning reverses; a few, such as Bear Stearns, have already gone belly-up. To prevent America’s $5.2 trillion home financiers, Fannie Mae and Freddie Mac, from following suit, Congress authorized a blank check to cover their losses, but even that generosity failed to do the trick. Now the administration has taken over the two entities completely, a stunning feat for a supposedly market-oriented regime. These bailouts contribute to growing deficits in the short run, and to perverse incentives in the long run. Market economies work only when there is a system of accountability, but C.E.O.’s, investors, and creditors are walking away with billions, while American taxpayers are being asked to pick up the tab. (Freddie Mac’s chairman, Richard Syron, earned $14.5 million in 2007. Fannie Mae’s C.E.O., Daniel Mudd, earned $14.2 million that same year.) We’re looking at a new form of public-private partnership, one in which the public shoulders all the risk, and the private sector gets all the profit. While the Bush administration preaches responsibility, the words are addressed only to the less well-off. The administration talks about the impact of “moral hazard” on the poor “speculator” who borrowed money and bought a house beyond his ability to pay. But moral hazard somehow isn’t an issue when it comes to the high-stakes speculators in corporate boardrooms.
How Did We Get into This Mess?
A unique combination of ideology, special-interest pressure, populist politics, bad economics, and sheer incompetence has brought us to our present condition.
Ideology proclaimed that markets were always good and government always bad. While George W. Bush has done as much as he can to ensure that government lives up to that reputation—it is the one area where he has overperformed—the fact is that key problems facing our society cannot be addressed without an effective government, whether it’s maintaining national security or protecting the environment. Our economy rests on public investments in technology, such as the Internet. While Bush’s ideology led him to underestimate the importance of government, it also led him to underestimate the limitations of markets. We learned from the Depression that markets are not self-adjusting—at least, not in a time frame that matters to living people. Today everyone—even the president—accepts the need for macro-economic policy, for government to try to maintain the economy at near-full employment. But in a sleight of hand, free-market economists promoted the idea that, once the economy was restored to full employment, markets would always allocate resources efficiently. The best regulation, in their view, was no regulation at all, and if that didn’t sell, then “self-regulation” was almost as good.
The underlying idea was, on the face of it, absurd: that market failures come only in macro doses, in the form of the recessions and depressions that have periodically plagued capitalist economies for the past several hundred years. Isn’t it more reasonable to assume that these failures are just the tip of the iceberg? That beneath the surface lie a myriad of smaller but harder-to-assess inefficiencies? Let me venture an analogy from biology: A patient arrives at a hospital in serious condition. Now, it may be that the patient has simply fallen victim to one of those debilitating ailments that go around from time to time and can be cured by a massive dose of antibiotics. In this case we have a macro problem with a macro solution. But it could instead be that the patient is suffering from a decade of serious abuse—smoking, drinking, overeating, lack of exercise, a fondness for crystal meth—and that it has not only taken a catastrophic toll but also left him open to opportunistic infections of every kind. In other words, a buildup of micro problems has led to a macro problem, and no cure is possible without addressing the underlying issues. The American economy today is a patient of the second kind.
We are in the midst of micro-economic failure on a grand scale. Financial markets receive generous compensation—in the form of more than 30 percent of all corporate profits—presumably for performing two critical tasks: allocating savings and managing risk. But the financial markets have failed laughably at both. Hundreds of billions of dollars were allocated to home loans beyond Americans’ ability to pay. And rather than managing risk, the financial markets created more risk. The failure of our financial system to do what it is supposed to do matches in destructive grandeur the macro-economic failures of the Great Depression.
Economic theory—and historical experience—long ago proved the need for regulation of financial markets. But ever since the Reagan presidency, deregulation has been the prevailing religion. Never mind that the few times “free banking” has been tried—most recently in Pinochet’s Chile, under the influence of the doctrinaire free-market theorist Milton Friedman—the experiment has ended in disaster. Chile is still paying back the debts from its misadventure. With massive problems in 1987 (remember Black Friday, when stock markets plunged almost 25 percent), 1989 (the savings-and-loan debacle), 1997 (the East Asia financial crisis), 1998 (the bailout of Long Term Capital Management), and 2001–02 (the collapses of Enron and WorldCom), one might think there would be more skepticism about the wisdom of leaving markets to themselves.
The new populist rhetoric of the right—persuading taxpayers that ordinary people always know how to spend money better than the government does, and promising a new world without budget constraints, where every tax cut generates more revenue—hasn’t helped matters. Special interests took advantage of this seductive mixture of populism and free-market ideology. They also bent the rules to suit themselves.
Corporations and the wealthy argued that lowering their tax rates would lead to more savings; they got the tax breaks, but America’s household savings rate not only didn’t rise, it dropped to levels not seen in 75 years. The Bush administration extolled the power of the free market, but it was more than willing to provide generous subsidies to farmers and erect tariffs to protect steelmakers. Lately, as we have seen, it seems willing to write blank checks to bail out its friends on Wall Street. In each of these cases there are clear winners. And in each there are clear losers—including the country as a whole.
What Is to Be Done?...
Find the rest of this article in November vanityfair.com (politics) Look for these two articles by Joseph E. Stiglitz
The $3 Trillion War, April 2008 (with Linda J. Bilmes)
The Economic Consequences of Mr. Bush, December 2007