Monday, October 6, 2008

Getting things right

Oct 4, 2008

By Joseph E. Stiglitz
IT DOESN'T take a genius to figure out that the United States' financial system - indeed, global finance - is in a mess.

The problems in the US economy and financial system have been apparent for years. But that didn't prevent US leaders from turning to the same people who helped create the mess, who didn't see the problems until they brought America to the brink of another Great Depression.

Congress may rescue Wall Street but what about the economy? What about taxpayers, already beleaguered by unprecedented deficits, and bills to pay for decaying infrastructure and two wars? In such circumstances, can any bailout work?

Rescuing Wall Street is a critically flawed approach. First, it relies on trickle-down economics: Somehow, throwing enough money at Wall Street would trickle down to Main Street, helping ordinary workers and home owners. Trickle-down economics almost never works. It is no more likely to work this time.

Moreover, it is assumed that the fundamental problem is 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 is going to change that.

The bad loans, in turn, have created massive holes in bank balance sheets, which have to be repaired. Any government bailout that pays fair value for these assets would be like providing massive blood transfusions to a patient suffering from vast internal haemorrhaging.

Even if a bailout comes quickly, there would be some credit contraction. The US economy has been sustained by a consumption boom fuelled by excessive borrowing. 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 bank balance sheets should be filled in a transparent way. In providing equity to Goldman Sachs, Mr Warren Buffet showed a way. By issuing preferred shares with warrants (options), one reduces the public's downside risk and ensures they participate in some of the upside potential.

This approach is not only proven, but it also provides both the incentives and wherewithal 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 - the government gets 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. Second, bankruptcy reform is needed to allow home owners to write down the value of their homes and stay in their houses. Third, government could assume part of a mortgage, taking advantage of its lower borrowing costs.

Investment banks and credit-rating agencies believed that significant value could be created by slicing and dicing securities. The new view is that real value can be created by unslicing and undicing. That is, pulling these assets out of the financial system and turning them over to the government. This requires overpaying for the assets, benefiting the banks.

Still, it is impossible for politicians to do nothing in such a crisis. So we may have to pray that they can somehow produce a rescue plan that works - or whose failure does not 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.

This is a condensed version of the original article by the writer who is a Columbia University professor and 2001 Nobel laureate in Economics.


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