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The Lessons of the North Atlantic Crisis for Economic Theory and Policy

From iMFdirect by Joseph Stiglitz:

 

In analyzing the most recent financial crisis, we can benefit somewhat from the misfortune of recent decades. The approximately 100 crises that have occurred during the last 30 years—as liberalization policies became  dominant—have given us a wealth of experience and mountains of data.  If we look over a 150 year period, we have an even richer data set.

With a century and half of clear, detailed information on crisis after crisis, the burning question is not How did this happen? but How did we ignore that long history, and think that we had solved the problems with the business cycle? Believing that we had made big economic fluctuations a thing of the past took a remarkable amount of hubris.

 

Markets are not stable, efficient, or self-correcting

The big lesson that  this crisis forcibly brought home—one we should have long known—is that economies are not necessarily efficient, stable or self-correcting.

There are two parts to this belated revelation. One is that standard models had focused on exogenous shocks, and yet it’s very clear that a very large fraction of the perturbations to our economy are endogenous.  There are not only short‑run endogenous shocks; there are long‑run structural transformations and persistent shocks.  The models that focused on exogenous shocks simply misled us—the majority of the really big shocks come from within the economy.

Secondly, economies are not self-correcting.  It’s clear that we have yet to fully take on aboard this crucial lesson that we should have learned from this crisis: even in its aftermath, the tepid attempts to fix the economies of the United States and Europe have been a failure.  They certainly have not gone far enough.  The result is that we continue to face significant risks of another crisis in the future.

So too, the responses to the crisis have not brought our economies anywhere near back to full employment.  The loss in GDP between our potential and our actual output is in the trillions of dollars.

Of course, some will say that it could have been done worse, and that’s true. Considering that the people in charge of fixing the crisis included some of  the same ones who created it in the first place, it is perhaps  remarkable it hasn’t been a bigger catastrophe.

More than deleveraging, more than a balance sheet crisis: the need for structural transformation

In terms of human resources, capital stock, and natural resources, we’re roughly  at the same levels today that we were before the crisis.  Meanwhile, many countries have not regained their pre-crisis GDP levels, to say nothing of a return to the pre-crisis  growth paths. In a very fundamental sense, the crisis is still not fully resolved—and there’s no good economic theory that explains why that should be the case.

Some of this has to do with the issue of the slow pace of deleveraging.  But even as the economy deleverages, there is every reason to believe that it will not return to full employment.  We are not likely to return to the pre-crisis household savings rate of zero—nor would it be a good thing if we did.  Even if manufacturing has a slight recovery, most of the jobs that have been lost in that sector will not be regained.

Some have suggested that, looking at past data, we should resign ourselves to this unfortunate state of affairs.  Economies that have had severe financial crises typically recover slowly.  But the fact that things have often gone badly in the aftermath of  a financial crisis doesn’t mean they must go badly.

This is more than just a balance sheet crisis.  There is a deeper cause:  The United States and Europe are going through a  structural transformation.  There is a structural transformation associated with the move from manufacturing to a service sector economy.    Additionally, changing comparative advantages requires massive adjustments in the structure of the North Atlantic countries.

Reforms that are, at best, half-way measures

Markets by themselves do not in general lead to efficient, stable and socially acceptable outcomes.  This means we have to think a little bit more deeply about what kind of economic architectures will lead to growth, real stability, and a good distribution of income.

There is an ongoing debate about  whether we simply need to tweak the existing economic architecture or whether we need to make more fundamental changes.  I have two concerns.  One I hinted at earlier:  the reforms undertaken so far have only tinkered at the edges.  The second is that some of the changes in our economic structure (both before and after the crisis) that were supposed to make the economy perform better may not have done so.

There are some reforms, for instance, that may enable the economy to better withstand small shocks, but actually make it less able to absorb big shocks.  This is true of much of the financial sector integration that may have allowed the economy to absorb some of the smaller shocks, but clearly made the economy less resilient to fatter‑tail shocks.

It should be clear that many of the “improvements” in markets before the crisis actually increased countries’ exposure to risk.  Whatever the benefits that might be derived from capital and financial market liberalization (and they are questionable), there have been severe costs in terms of increased risk.  We ought to be rethinking attitudes towards these reforms—and the IMF should be commended for its rethinking in recent years.  One of the objectives of capital account management, in all of its forms, can be to reduce domestic volatility arising from a country’s international engagements.

More generally, the crisis has brought home the importance of financial regulation for macroeconomic stability.  But as I assess what has happened since the crisis, I feel disappointed.  With the mergers that have occurred in the aftermath of the crisis, the problem of too-big-to- fail banks has become even worse.  But the problem is not just with too-big-to-fail banks.  There are banks that are too intertwined to fail and banks that are too correlated to fail.  We have done little about any of these issues. There has, of course, been a huge amount of discussion about too- big-to-fail. But being too correlated is a distinct issue.  There is a strong need for a more diversified ecology of financial institutions that would reduce incentives to be excessively correlated and lead to greater stability.  This is a perspective that has not been emphasized nearly enough.

Also, we haven’t done enough to increase bank capital requirements.  Missing in much of the discussion is an assessment of the costs vs. benefits of higher capital requirements.  We know the benefits—a lower risk of a government bailout and a recurrence of the kinds of events that marked 2007 and 2008.  But on the cost side, we’ve paid too little attention to the  fundamental  insights of the Modigliani‑Miller Theorem, which explains the bogusness of arguments that increasing capital requirements will increase the cost of capital.

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