Freefall:America, Free Markets, and the Sinking of the World Economy
By Joseph E. Stiglitz (Nobel Laureate, Economics 2001)
William K. Black, Associate Professor of Economics and Law, University of Missouri – Kansas City
This book is about a battle of ideas, about the ideas that led to the failed policies that precipitated the crisis and about the lessons we take away from it (p. xii).
Anyone seeking to explain this “battle of ideas” must address three questions:
- What “ideas” are producing environments in so many nations that create the perverse incentives that have led to recurrent intensifying crises in many nations?
- Why did these ideas become dominant in so many nations?
- Why have these ideas become more dominant even as they have produced greater crises?
Stiglitz’ answers to these questions are:
- Neoclassical economics has become ferociously anti-governmental. Financial markets, absent effective regulation, generate perverse incentives that cause crises.
- The United States, through our universities and through institutions such as the International Monetary Fund (IMF), exports neoclassical economics and economists to the world and gives them the power to set policy in most nations.
- Stiglitz suggests several reasons why economists have become ever more married to their models as they fail spectacularly. Self-interest and power are part of the answer (p. 42). Neoclassical economists are useful to big finance because they are willing to give the wrong answers. The more that reality falsifies their models, the more valuable neoclassical economists are to big finance in fending off regulation, in creating models that overvalue assets (allowing huge bonus payments), and in claiming that the prices their own models generate after the crisis should be disregarded because the problem isn’t asset quality, but rather liquidity and market confidence (p. 48). Economists have become financial holocaust creators and deniers.
- But Stiglitz’s primary argument is that anti-regulatory economists have remained intellectually dishonest for the saddest of reasons – they lack the courage to admit that their theories have been falsified and that the policies they have championed caused the crises (p. 48).
Stiglitz documents America (and much of the world’s) descent into crony capitalism (pp. 41-42, 122). He explains that while other bankrupt firms settle claims on credit default swaps (CDS) at 13 cents on the dollar, Paulson and the Fed pressured AIG to pay favored systemically dangerous institutions (SDIs) such as Goldman Sachs 100 cents on the dollar – with the public bearing the cost of this secret subsidy (p. 49). His broader point is that the neoclassical triumph in the battle of ideas (and its triumphalism about winning the battle) led not to the promised utopia of efficient, stable markets and growth, but rather to economic stagnation for the middle class, a catastrophic fall for the working class, and recurrent crises.
Stiglitz emphasizes that none of this is due to bad luck. The Great Recession was not analogous to the “100 year flood.” Crises have happened in a broad range of nations because when finance becomes unregulated it becomes vastly too large and too powerful and uses its power to corrupt or evade restraints on its power. This means that crony capitalism is a severe danger and will often occur.
- Their victory over America was total. Each victory gave them more money with which to influence the political process. They even had an argument: deregulation had led them to make more money, and money was the mark of success. Q.E.D. (p. 10).
Stiglitz emphasizes that finance can become hyper-dominant in a broad range of political settings throughout the world. One of his most candid themes is that the Obama administration continued Bush’s policy of crony capitalism (pp. 46-49).
This book is weakest in providing a concrete explanation of the mechanism that caused this, and prior, crises. Stiglitz appropriately identifies three aspects of why the ideas he criticizes produce an environment that causes crises:
- Deregulation, (and, even more, desupervision)
- Modern compensation (executive and “agents”, e.g., outside auditors, rating agencies, and appraisers)
- Accounting. Criminologists recognize that accounting is the “weapon of choice” for financial frauds and that the first two elements interact to optimize an environment for accounting fraud.
The tension is that Stiglitz refers primarily to “risk” and views the difference between “gambling” and fraud as being a “fine line” (p. 125), using the S&L debacle as his example (p. 125) and citing Ed Kane and George Akerlof and Paul Romer, respectively, for this proposition. But this misreads what Akerlof & Romer wrote and it misses the fact that they wrote later than Kane with the benefit of dramatically better data that disproved Kane’s hypothesis that the debacle was primarily caused by (honest) “gambling for resurrection” by already insolvent S&Ls (Black 2005). As the national commission into the causes of the S&L debacle found, at “the typical large failure” “fraud was invariably present.” (“Traditional” S&Ls did engage in honest gambles for resurrection by only moderately reducing their exposure to interest rate risk in 1983-86. They won those gambles when interest rates fell sharply, which sharply reduced the cost of resolving the debacle. Note that they reduced rather than expanded their risk exposure – contrary to the “gambling” hypothesis.)
Akerlof & Romer’s title says it all: “Looting: Bankruptcy for Profit.” They agreed with the insight that regulators and criminologists had reached about the debacle – fraud is a “sure thing.” A lending institution that follows the classic four-part strategy for optimizing accounting fraud is mathematically guaranteed to report record profits:
- Grow rapidly
- Make loans regardless of the borrower’s ability to repay (this is essential to being able to grow rapidly while charging a premium yield)
- Extreme leverage
- Grossly inadequate loss reserves
The “typical” large nonprime lender failure during this crisis fits this pattern. The first three parts of the strategy are well known, but loss reserves have been ignored in discussions of the crisis. Overall, loss reserves fell to “record lows” for four straight years even as (1) the FBI warned in September 2004 that there was an “epidemic” of mortgage fraud (and predicted that it would produce an economic crisis if it were not contained), (2) underwriting standards disappeared (which is deliberate and essential to part two of the optimization strategy), and (3) warnings of the housing bubble became common and strident. Each of these factors should have led to far larger loss reserves, collectively they should have led to loss reserves so large that the lenders would have had to report that nonprime lending was (in economic reality) unprofitable. Instead, loss reserves virtually disappeared. Again, this is not an issue of a “fine line.” We are talking about loss reserves that were two orders of magnitude too small.
So I would add another reason why economists have been so blind to the causes of these crises – they have been taught from their freshman year that accounting doesn’t matter (efficient markets must “see through” accounting) and that no rational person would base a business decision on accounting. In reality, accounting fraud routinely cons financial markets and accounting is the primary driver of decisions by financial firms.
The biggest story in the bailout is barely known because it is an accounting story. The big banks, with Bernanke’s support, used their political muscle to cause Congress to extort FASB to gut the accounting rules so that lenders did not have to recognize their loan losses. Absent that rule change, the banking “profits” would have been losses and they would not have been able to pay themselves over a$100 billion in executive bonuses.