The Financial Crisis - Joseph Stiglitz

Nobel Prize-winning economist Professor Joseph Stiglitz served as Chairman of the Economic Advisors under President Bill Clinton and Chief Economist at the World Bank, which makes him well placed to analyse the current financial crisis and suggest a possible way forward. He shared his views as the keynote speaker at the opening ceremony at the IBA Annual Conference in Dublin.

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It’s five years since the beginning of the recession, six years since the breaking of the bubble. The downturn continues with no recovery really imminent. In many of the countries – of Europe particularly – GDP is still less than it was before the crisis. The question, obviously, is asked, how long will it last? Well, one way of thinking about that is to think back to the Great Depression. This is not supposed to make you feel comfortable! The Great Depression is usually dated as beginning of 1929. If you remember, looking at this from a perspective of the United States, in 1937 we hadn’t recovered, and we went back into a double-dip recession. The reason? President Roosevelt was persuaded to try a dose of austerity because of fear of deficits.

The economy remained weak, and who knows how long it would have lasted without World War Two. It was World War Two that brought the United States out of the Great Depression and, as I’ll explain a little later, actually provided the basis of the long term recovery that happened in the years after. But there are some important lessons from this, and that is that economies don’t recover on their own, or at least don’t recover quickly enough. There’s a famous quip when some economist said, ‘Oh, don’t worry about it, in the long run the economy will recover.’ And Keynes’ response was ‘Yes, but in the long run we’re all dead.’


Remember, the recession caused the deficit, not the other way around



Joseph Stiglitz keynote speech, IBA Annual Conference 2012

The conventional wisdom focuses on the financial crisis. The diagnosis was fairly simple: the financial sector had caused the problem; bad banking, now it’s regulations that allowed a whole host of bad practices to occur. So, what is needed is to put the banks back into the hospital to change the plumbing a little bit, it’ll take a year and a half, two years, give it time to heal. Meanwhile, we’ll have a mild stimulus to keep the economy going and then, with the financial sector healed, we’ll go back to the good old days of before the crisis. It should be clear that that diagnosis was wrong. It’s been far longer than two years and the economies, both in the United States, in Europe, are not recovered. The diagnosis was wrong and so, not surprisingly, the prescription was wrong. It was more than a financial crisis, even if the financial crisis played a critical role. So, what I want to do this evening is try to explain what I think are some of the underlying problems. I’m going to begin by talking about the United States, because I think the problems are simpler there, then I’m going to talk about Europe, and then I’m going to talk about the one glimmer of hope, and that’s the emerging markets.

USA: in need of structural transformation
Focusing on the United States, in some ways the analysis is simpler, and it’s clear to me that it’s more than a financial crisis. The story was that the absence of effective banking would impede investment, and once the banks were restored, investment would be restored. Well, investment outside of real estate has largely returned to normal in the United States. In fact, the large firms are sitting on large amounts of cash, estimated at a couple of trillion dollars. What that illustrates is, it’s not the lack of finance that’s holding back the US economy; the banks are not fully fixed, but clearly it’s not the financial sector that’s the problem. But the financial crisis has made the underlying problems worse. It did this in two ways: it left in its wake excessive household leverage and an overhang of real estate. And that has important implications, especially in those countries like Ireland and Spain where they outdid the United States in their bubble. It’ll be hard to restore the economy to full employment, because of the gap in aggregate demand; just look at the numbers in the United States. Before the crisis, real estate represented 40 per cent of all investment. Today it’s less than half of that. The only good news is that, in this period of the real estate bubble, the housing construction was really shoddy so, where houses won’t last that long, maybe in ten or 15 years we will need to have more construction going. But it won’t happen right away.

What about this issue of de-leveraging? There’s a view that once we de-leverage, once the household debt comes down, consumption will go up. Every once in a while you hear from the administration or somebody in the Fed say the American consumer is coming back. I think it’s not likely, and if he is coming back the way he was, we should be worried. The bottom 80 per cent of Americans were consuming 110 per cent of their income. The personal savings rate now has gone up from near zero to a little over four  per cent. That’s still far below our traditional average, and far below what it ought to be. So, that’s why I think even after de-leveraging, and there’s been some de-leveraging, I don’t think we’re going to have consumption anywhere near back to where it was before the crisis. So, that means in terms of demand, what gives an economy its energy, these two elements, housing construction, real estate construction, and consumption, are going to be markedly weaker than they were in the years before the crisis.

There are some underlying problems. One I want to focus on particularly is the need for a structural transformation in the United States. And what I’m going to say applies as well to Europe. The structural transformation is the movement away from manufacturing. In a way, we are a victim of our own success; there was such an increase in productivity – exceeding the increase in demand – that employment inevitably shrank. People have to move out of manufacturing and go elsewhere, mostly into the service sector. In Europe and America these problems are compounded by globalisation, meaning a shift of comparative advantage, so that a larger share of the shrinking global employment in manufacturing will be in emerging markets – a smaller share will be in the United States and Europe. Even China now has markedly decreased employment in manufacturing. A fundamental observation is that markets often don’t make these structural transformations easily, and that’s why government needs to take a major role. But unfortunately, government today is not doing what it should, and in fact is stepping back.


More than 50 per cent of the young people are unemployed. This is a period when young people ought to be increasing their skills; instead, their human capital is weakening and deteriorating,



And that brings me to the second further problem of what is going on in the United States, and that is contractionary government policies. I know in Europe there’s a lot of discussion about austerity, but in fact in the United States we’ve also had our dose of austerity, in a much more quiet way. Government employment today is more than 600,000 lower than it was before the crisis, and if we had a normal increase, reflecting the normal increase in the labour force, we would have added some 1.2 million workers to the government sector. So, the deficiency in government spending, in government employment, is one of the major factors contributing to the weakness in our economy. At the same time, these cutbacks are hurting our ability to make the transformation that I described before.

Where do we go from here? What are the answers? Well, first, let me say that monetary policy, QE3, won’t make much difference. I know there’s a lot of excitement about it; QE2 didn’t make much difference, QE3 is likely to make even less of a difference. What I am afraid of is that political gridlock will prevent what is needed to be done. And there are two things, at least, that should be obvious and are essential. The first is that we have to deal with the foreclosure crisis. Remember, it was the housing problem that started it.

There are a number of proposals. Restructuring the debts, a Homeowners’ Chapter 11. The second is a fiscal stimulus. The first fiscal stimulus worked. Had it not been for this fiscal stimulus, unemployment in the United States would have peaked at something like 12.5 per cent; it peaked at around ten per cent, so it did bring it down, but it was too small. The question that I’m often asked is, can we afford the stimulus? I would respond that we can’t afford not to do it; it’s the best way to address our looming deficit and debt. Remember, the recession caused the deficit, not the other way around, and right now the United States can borrow, and at negative real interest rate, and one of the good news of the fact that we’ve under-invested in public sector, in technology, in infrastructure, in education, is that we have ample supply of investments yielding very high real rates of return. So, in fact, these investments would improve our national balance sheet; it would enable us to address some of our fundamental problems, our structural transformation, our problems of inequality, and they would lay the foundations for our long term economic growth.

Europe: right politics, wrong economics
Let me turn now to Europe, having solved America in ten minutes! The only positive thing that one can say about Europe is that its problems make Americans feel that things could be worse. Europe faces some of the same problems that I talked about in the United States, such as the problem of structural transformation. The depth of the problems should be clear. Spain and Greece are in depression, and that’s the only word you can ascribe to a situation where 25 per cent of the people are unemployed, which was the unemployment rate in the Great Depression. More than 50 per cent of the young people are unemployed. This is a period when young people ought to be increasing their skills; instead, their human capital is weakening and deteriorating – they’re becoming alienated. I think the future of these countries, the stability, the democracies are in jeopardy; the political consequences are becoming clear as separatist movements such as in Catalonia grow. Again, I think the problem is that the diagnosis in Europe of what went wrong was wrong and, as a result, the prescription was wrong.


One should remember austerity has almost never worked. This is an idea that’s been tried over and over again



What one hears commonly is that the problem is excessive debt; but Europe’s debt-to-GDP ratio was actually better than the United States. If Europe changed its economic framework, it could have access to credit, access to funds – at the same negative real interest rates that the United States could. Before the crisis, Ireland and Spain had a surplus, not a deficit; they fulfilled all the conditions of what are called the Maastricht Convergence Criteria. Because they misdiagnosed the problem as over-spending, the prescription has been, quite naturally, to cut back on spending: austerity. But one should remember austerity has almost never worked. This is an idea that’s been tried over and over again; back in 1929 Herbert Hoover tried it, succeeded in converting the stockmarket crash into the Great Depression – there were some other factors too. The IMF has tried this experiment; in East Asia I saw it in the years that I was at the World Bank; they tried it in Latin America; each time it succeeded in converting downturns into recessions, recessions into depressions.



The fundamental problem with Europe is very simple: it’s a flawed currency arrangement. Europe, the eurozone, was not based on economics, it was based on politics. The economics was very clear. My colleague at Columbia, Robert Mundell, got a Nobel Prize for his work on what were the conditions under which a group of countries could share a common currency. And European countries did not satisfy those conditions. And I think that the European leaders knew that at the time, but the hope was that somehow, in the ensuing years, there would be a change that would make the system work.

What is needed is actually a structural change of the euro arrangements. It’s happening, but the problem is the speed of the political change is too slow for the economics. And let me give you an example of what is happening in the financial sector, in the banking sector. There’s a kind of dynamic instability. Just put yourself in the position of somebody having money in a Spanish bank. You worry about the viability of the Spanish bank, and every country’s banking systems are in effect backed up by their government – we saw that in the 2008 crisis. Backing any banking system is actually the belief that the government will bail it out in times of crisis. But, if the Spanish government is weak economically, there’s no confidence and so money starts flowing out of the Spanish banking system. But it’s even worse because then people start worrying: will they be able to stay in the eurozone? And so then there’s a risk of currency loss, a devaluation. But as money moves out of the Spanish banking system, the Spanish economy gets weaker. The viability of credit gets weaker and without access to credit, especially for small-to-medium-sized enterprises the economy gets weaker. Tax revenues get weaker and the result of that is confidence in the government and its ability to bail out the bank gets even more eroded and that process then reinforces itself.

This was a problem. This kind of dynamic instability, the financial system was apparent from the beginning, but attention wasn’t focused on it. What is needed is quite clear. You needed to have a common banking system, but a common banking system not just with common supervision but common deposit insurance and common resolution and unfortunately the discussions in Europe so far have focused only on common regulation, common supervision and the two other pieces haven’t been there. And as long as those two other pieces are not there, the system will continue to unravel.

The second thing that needs to be done is the mutualisation of debt. Again, the viability of countries that are highly indebted, they can only borrow at very high interest rates that make them, because of the high interest rates, uncompetitive. So that weakens their economy and it’s, again, a downward vicious circle. So, among economists, I think, what I just described are two of the minimum reforms that have to be done. It seems clear that either there will need to be more Europe or less Europe. The current in-between state is not really viable. More Europe would entail, as I say, mutualisation of debt and in a common banking framework. Less Europe will mean a breaking up of the 17-nation eurozone – at least in the way that we know it.

There’s another increasing consensus among economists that if the euro does break up, the easiest, least destructive way would be for Germany to leave. The alternative, actually both ways, will be a boon to the legal profession. The opportunities that it will afford you for restructuring contracts, bankruptcies, it will be a godsend. Well, the easier way probably won’t happen, but the bottom line is that Europe is likely to face turmoil for some time to come, no matter which direction it takes.

Some cause for optimism
Finally, let me turn to the one part of the world where there is a little basis for optimism: the emerging markets. They weathered the 2008 storm much better than any of us thought they would. China, of course, was the most resounding success, but India was too. Now, there’s a slow-down in both China and India, but one has to keep it in perspective. The slow-down, they’re talking about gross slowing down from nine per cent to seven per cent. I think all of us would be quite pleased if we could grow at half of that seven per cent. Actually in China there’s a lot of support for slower growth. The focus is on quality of growth, not quantity and the belief that a slightly slower growth would lead to a higher quality of growth. I believe that China has the instruments, the resources, the incentives and the knowledge to make sure that growth doesn’t slow significantly below the seven per cent level. What is clear is that growth in the emerging markets would not be strong enough to pull Europe and the United States out of their doldrums.


There’s a risk that the promise of justice for all will become justice for those who can afford it



Even in the years before the crisis, in most countries, there was growing inequality. But the economic downturn has exacerbated these problems greatly. Median income (that’s half above, half below) in the United States today is roughly back to where it was in 1996 and median wealth is back to where it was in the early 90s. Median real incomes for full-time male workers are back to the level that they were more than 40 years ago, in 1968. So there’s been a dramatic increase in inequality. Just one more number highlights the role of that economic downturn, in 2010, the year of recovery, 93 per cent of the growth in the United States went to the upper one per cent – probably many of you in this room. So what that indicates is that somehow things have become unbalanced.

Economic inequality leads to political inequality and for those of you in the legal profession it presents, I think, a particular challenge. There’s a risk that the promise of justice for all will become justice for those who can afford it. In the United States, and I know some other countries, legal aid is being cut back and so those who can’t afford access to legal assistance can’t get it and I think it’s important that the IBA does what it can to make sure that in all countries there is this access to justice for all.
I believe that in both Europe and America it is clear what the economic agenda should be.. The problem is, will America’s divided politics allow this to happen? And will Europe have enough solidarity to allow this to happen, to allow the ‘more Europe’ solution that I described before, the kind of ‘more Europe’ solution that is absolutely necessary if the euro is to survive? In any case, what is clear is that these are as troubling times as we have faced in three-quarters of a century.