Too big to fix? Joseph Stiglitz says no

Some mainstream economists say the discipline deserves the beating it has been getting lately. Many believe the standard model is irreparably broken.

By Peter Hulm

Economists in general agree on one thing: their core beliefs are much more similar than the issues on which they disagree, no matter how it seems in the newspapers.

So when such a contentious group talks about a crisis in economic theory and teachers like Dirk Helbing of ETH Zurich declare "the whole framework may need to be reconstructed", we had better sit up and pay attention.

We all want to know how to get out of the current mess and escape future crises. But today even Carsten Detkin of the European Central Bank, after five years of the ECB tackling economic crisis, talks of "the uselessness of market price-based indicators for early warning purposes".

What good are you?

Joseph Stiglitz, the Nobel Economics Prizewinner who made his reputation with work solving exactly such problems, is not surprised that economists are receiving a hard time from the public. As Stiglitz told a packed lecture hall of his compeers at ETHZ (the Zurich equivalent of MIT), people are asking: "If you can't predict the most important event in 75 years, what good are you?"

The most important point was not that economists failed to anticipate the crisis, he said. It was that their predictions of how to put things right have not worked.

This is partly because currently they work from an "Asian model" with only one actor (no theory of debt problems) and assume rationality in economic behaviour. They cannot deal with behaviour that is "just, say, stupid".

No such thing as a credit bubble

Their frameworks also presume that all the shocks come from outside. In the standard model there can be no such thing as a credit bubble. As a result, even after the 2007-8 collapse, economists were claiming the effects were "contained", despite the evidence.

For information about what economies are reliable, he noted in a presentation to the three-day Latsis Foundation symposium, Central Banks often rely on credit rating agencies, whose performance has been "quite frankly deplorable" in a "race to the bottom" for commercial success.

The mystery of recovery

Similarly, though financial markets are supposed to be immediately self-correcting, "there is no good economic theory that explains why [recovery] is taking so long."

The failure to control the crisis resulted from misreading Adam Smith's remarks on "the invisible hand" governing free markets, he told the economists. "The reason why the invisible hand was invisible was because it was not there."

Incentives to risk taking

Large "too-big-to-fail" institutions have an incentive to engage in risk taking. This is true, too, of financial systems, so that a market structure that evolves on its own is likely to face excessive systemic risk.

As a result, we need a new paradigm of how economies, markets and policies work, Stiglitz insisted. Standard models don't even incorporate issues of credit -- and therefore don't have much to say about repairing credit systems. The key problem is that lenders do not know who are good borrowers.

And the economic models used by Central Bankers often have little to say about banking itself.

Learning the lessons

Half an hour later, in a panel discussion with other economists and bankers on lessons to be learned from the recent crisis, Stiglitz was even tougher on central bankers, investment houses and financial traders.

It was as if the ECB told government banks they had to buy insurance against a collapse, and then told them it could not pay out on the insurance, he suggested. In turn, "banks have been using fear as a cudgel to get what they want" -- governments to prop them up.

In the case of the American insurance company AIG, the Federal Reserve gave the firm a credit line totalling $150 billion to keep it afloat. But no-one knew what happened to the money that went to AIG, until Bloomberg pursued the issue in U.S. courts. Fed chairman Ben Bernanke fought against revealing the destination of the cash. The case went as far as the Supreme Court but by that time, everyone knew where the money had gone.

Where have all the dollars gone?

The largest recipient was the troubled Goldmann Sachs investment firm, said Stiglitz. But more interesting was that the next two recipients were French banks. "Why didn't the French (central) Bank save it?" he asked. This is what central banks are supposed to do.

One suspicion was that the money had gone back to the United States, he reported, and this could have been why the French central bank kept its hands away from the deal.

All these failings were in the system installed 12 years before, he pointed out. "They should have seen this."

Fundamental fragility

The European crisis has shown that large-scale instability does not necessarily result from big events. Small national crises can lead banks to face pressure and investors to pull out money, making it difficult for governments to support the banks as they are supposed to.

The economic models we operate increase fundamental fragility in the system. With lower interest rates, firms increase their debt-equity ratio (as before the crisis), and the probability of fragility increases.

Computer vs computer

But the crisis should also make economists aware of the "failure of our price system", Stiglitz observed. Over 60% of trades in U.S. stock markets are now carried out by computers. So how can economists talk of prices being "discovered" by negotiation according to the conventional model?

What we have are "computers trying to outsmart other computers," Stiglitz noted. As a result, at one point several trillion dollars -- enough to pay for several wars -- were wiped off stock values in 20 minutes (they were restored a few minutes later).

Transparency, no thanks

Rama Cont of the Imperial College, London, warned that even calls for transparency in financial transactions could fail to get us better information despite the crisis.

He served on an advisory panel in 2010 that looked at the interbank swap market, worth $450 trillion. They discovered there is "absolutely no requirement" to publish swap prices either before or after a trade. The task force suggested the dealers publish each day's average prices, and the traders said they could put a system in place within 48 hours.

Some 20 banks control 80% of this swap market and were ready to go along, but the SSC board (of about 10 people) rejected the idea. "We never heard why it was rejected."

Cont said he heard the proposal was defeated by one vote, and shortly afterwards one of the SSC governors joined one of the banks as chief regulatory advisor.

Capital is not so costly

Jürg Blum of the Swiss National Bank told the symposium he was shocked that industry "has managed to sell the idea that capital is excessively costly". Banks have only to keep 2% of their reserves as capital and can invest or loan the rest. Any entrepreneur who went to a bank proposing to provide just 2% equity would be "kicked out of the building". But banks can still operate without having to build up a bigger buffer against shocks.

The ATM money hole

Stiglitz said former Fed chair Paul Volcker had it right when he declared that no financial instrument devised by the system had proved any value to society. Except the ATM hole in the wall money machine, added Volcker. But that was a British innovation, Stiglitz pointed out.

Didier Sornette of ETH Zurich warned his fellow economists against trying to model in a simplistic way the complexity of the world using ideas from outside economics. "We need to go back to simplicity," he declared. Just forcing banks to keep back larger proportions of their holdings was as good as sophisticated models of market processes that fail to predict or help stop breakdowns.

The crisis in the financial system is only one of several that make this a historic turning point, he said. Environmental, climate, agro-industry and pharma-health crises face us too over the coming decades, Sornette predicted.

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