Speculation Nation

The banks must be restrained and refocused or all the efforts to support the system with public funds are just adding to the debt, the imbalance in wealth, the malinvestment, and misappropriation of capital that has undermined the real economy.

A large part of the problem is that all the obvious things that Joe Stiglitz points out in this essay were denied and dismissed repeatedly at every turn by Alan Greenspan and the Fed, Wall Street and their economists-for-hire, and the financial media.

And the pity is that we have not yet made any progress in actually fixing the problem and restoring balance to the system. The deception and fraud continues impeded only by the dire condition of the victims. Without reform, the financial sector will merely go in search of others.

The New Republic
Falling Down
by Joseph Stiglitz
Wednesday, September 10, 2008

No manufacturing. No new ideas. What's our economy based on?

...The task of unraveling all that went wrong in our financial system is a difficult one, but in essence the financial system's latest innovation was to devise fee structures that were often far from transparent and that allowed it to generate enormous profits--private rewards that were not commensurate with social benefits...

One should have suspected that something was wrong with the economic system when millions of Americans owed billions to credit card companies and banks in "late fees," "penalties," and a variety of other charges, transforming a high annual interest rate of 20 percent into a truly usurious effective interest rate of 100 percent or more for those who fell behind in their payments...

Perhaps the worst problems--like those in the subprime mortgage market--occurred when non-transparent fee structures interacted with incentives for excessive risk-taking in which financial managers got to keep high returns made one year, even if those returns were more than offset by losses the next. Behind the subprime crisis were mortgages designed to encourage repeated refinancing of homes--a pyramid scheme that generated billions of dollars in fees for the mortgage company as long as home prices continued to soar...

To put it another way, had those in the financial sector allocated capital and risk in a way that fueled the economy, they would have had handsome profits. But they wanted more, and so established incentive structures that encouraged gambling. If they gambled and won, they could walk away with a share of the profits. If they gambled and lost, the investors would bear the consequences. It was almost as if the entire financial system was converted into a giant casino in which the system was rigged to guarantee those running the games huge returns, at the expense of the players.

But in Las Vegas and Atlantic City, the games are near zero-sum: The gains of the casino owners approximately equal the losses of the players. The financial-system-as-casino, on the other hand, is a negative-sum game. Those on Wall Street may have walked off with billions, but those billions are dwarfed by the costs to be paid by the rest of us...

The current woes in America's financial system are not an isolated accident--a rare, once-in-a-century event. Indeed, there have been more than one hundred financial crises worldwide in the last 30 years or so. Here in the United States alone, we have had the S&L crisis in 1989, the dot-com/WorldCom/Enron problems of the early years of this decade, and now the subprime-morphing-into-the-beyond-subprime collapse.... In each of these instances, financial markets failed to do what they were supposed to do in allocating capital and managing risk...

In short, the problem with the U.S. economy is not that we have allocated too many resources to the "soft" areas and too few to the "hard." It is not necessarily that we have allocated too many resources to the financial sector and rewarded it too generously... Too much energy has been spent trying to make an easy buck; too much effort has been devoted to increasing profits and not enough to increasing real wealth...

Joseph Stiglitz is University Professor at Columbia University, winner of the 2001 Nobel Memorial Prize in Economics, and co-author of The Three Trillion Dollar War.