Mamdani response to Stilglitz
presentation
Publish Date: Jul 18, 2012
Your Excellency, Mr. President; the Chair, the Honorable
Minister of Finance; the Honorable Governor of the Bank of Uganda and the
Honorable Deputy Governor, Bank of Uganda, I assume that the Bank of
Uganda has asked me to be a discussant hoping I would raise questions they do
not feel comfortable raising.
I will take a cue from them and ask Professor Stiglitz
questions hoping he will give responses that I do not quite feel comfortable
giving.
I shall focus on four issues and I will ask four questions.
The first concerns the Clinton
years. The second is about Professor Stiglitz definition of the problem,
as one of “market failure.”
The third question focuses on the contemporary global
crisis; I call for a more comprehensive definition of the crisis, from the
point of view of society and not just the state and market binary that frames
Professor Stiglitz’s discourse. Finally, I ask that Professor Stiglitz
situate our own crisis – the crisis of Uganda
and East Africa – within an expanded frame.
1. The Clinton
Years
Deregulation of the financial system in the US began with the Clinton administration’s repeal of key
sections of the Glass-Steagall Act of 1933. That Act had separated
commercial and investment banking since the Great Depression era. The
repeal of that Act was key to the deregulation of derivatives.
In 2008, Clinton
denied responsibility for refusing to regulate derivatives. He changed
his mind in 2010, then blaming his advisors, among whom were Treasury
Secretaries Robert Rubin and Larry Summers and the Chair of his Council of
Economic Advisors, Joe Stiglitz. Larry Summers went on to become
President of Harvard University.
Joseph Stiglitz went on to be Chief economist of the World
Bank and then professor at Columbia
University. Summers
showed little remorse for his role in the deregulation era. Joe Stiglitz,
in contrast, became the best known critic of deregulation.
My first question is not new. Academic reviewers of
Stiglitz have often wondered when he saw the light: did Professor Stiglitz
oppose deregulation at the time or change his mind when its consequences became
clear? Should we understand his critique of deregulation as foresight or
hindsight, foresight in 1996 or hindsight after his time as Clinton’s senior policy advisor?
Professor Stiglitz addressed this issue in a book he wrote
on the Clinton
era, a book titled The Roaring Nineties: A New History of the World’s Most
Prosperous Decade. The question I am interested in was posed by an academic
reviewer of the book, Robert Pollin
of Department of Economics at University of Massachusetts
at Amherst.
Let me quote Professor Polin:
“… at what point did Stiglitz, in his role as a senior Clinton policy advisor,
become convinced of the severe damage that would result from deregulation? … As
one important example, the general tenor of the 1996 Economic Report of the
President, written under Stiglitz’s supervision as Chair of the Council of
Economic Advisors, is unmistakably in support of lowering regulatory standards,
including in telecommunications and electricity.
This Report even singles out for favorable mention the
deregulation of the electric power industry in California—that
is, the measure that, by the summer of 2002, brought California to the brink of economic
disaster, in the wake of still more Enron-guided machinations.”
Why is the question important? Like the rest of us,
Professor Stiglitz has a right to change his mind. The point of asking
him this question is to have some information about how his thinking has evolved
on this subject. As the reviewer asked: “Was there a moment of epiphany, like
Saul of Tarsus falling off his mule?
How many possible disaster scenarios did he really
anticipate, and how much has he realized only more recently, after observing
and ruminating with hindsight?” Did the crisis authored by the Clinton administration of
which he was a leading member just confirm his intuition or did it also teach
him something new?
The answer to this question would tell us something about
his intellectual journey. That would allow us to pose a more contemporary
question: Should not the present global crisis lead Professor Stiglitz to
develop his thought further? My point is that this question is not just
one that should interest Professor Stiglitz’s biographer; it is of theoretical
significance. Let me explain in terms that a lay person can understand,
which will also allow me to pose my second question.
II. Why Call it Market Failure?
Professor Stiglit’s theoretical work is on the economics of
information. Traditional economics, both classical and neoclassical, has
been dominated by two related assumptions. The first is what Adam Smith
called ‘the invisible hand,’ the assumption that free competition leads to an
efficient allocation of resources.
The second is a related assumption in welfare economics,
that issues of distribution should be viewed as completely separate from issues
of efficiency. It is this methodological "separation" between growth
and distribution which allows economists to push for reforms which increase
efficiency, regardless of their impact on income distribution.
It is the methodological basis of what we know as the
“trickle down” school in economics. Professor Stiglitz’s great
contribution has been to challenge both these assumptions. As he has
shown, asymmetric information is a pervasive feature of how real-world markets
operate. The free market is an ideological myth. In the real world,
imperfect information makes for imperfect markets.
For Stiglitz, this means that governments need to strongly
and effectively regulate what goes on in markets. The point is to level
the information field as much as possible so that markets may function with a
modicum of efficiency and fairness.
I have simplified the matter but I think it gives you an
idea of the contribution for which he justly received the Nobel Prize.
In the three decades that preceded Stiglitz, economists had
identified important market failures, but in limited areas, such as
externalities like pollution, which require government intervention.
But the case they had made was for limited government
intervention in limited areas. Professor Stiglitz made a more general
case. He showed that markets are always imperfect since they are always
characterized by imperfect information, why government intervention has to be a
constant presence in the market.
Here then is my second question: Why call this “market
failure”? The term “market failure” suggests that markets normally
function properly and that “market failure” is an exceptional occurrence.
It is an appropriate term to describe the thought of
pre-Stiglitz economists who focused on externalities like pollution to call for
government intervention in select fields. But it hides the real
significance of Professor Stiglitz’s contribution which is to redirect our
thinking away from failure as an exceptional occurrence to imperfection as the
normal state of markets.
Like its twin term “state failure,” the term “market
failure” focuses our attention on the exception rather than the norm. But
we are not talking of an occasional lapse in how markets function; rather, we
are talking of the regular state of markets, of how imperfect markets are when
they function the way they are supposed to function.
Information is always imperfect and so are markets.
What is involved here is a methodological shift from the exception to the
norm. This is a shift of paradigmatic significance. “Market
failure” is an unfortunate term because it hides the fundamental character of
this shift.
III. The Problem is Not Just Economic
Before discussing its limits, I will summarize Professor
Stiglitz’s response to the problem he calls “market failure.” Professor
Stiglitz attributes “market failure” to “lack of transparency.”
He has several recommendations on how to check market
failure. The first is that government needs to bridge the gap between
social returns and private returns, both to encourage socially necessary
investment as in agriculture and to discourage socially undesirable investment
as in real estate speculation.
Second, the government may set up specialized development
banks. In support, he cites the negative example of America’s private banks and their “dismal
performance” alongside the positive example of Brazil’s development bank, a bank
twice the size of the World Bank, and its “extraordinary success” in leading
that country’s economic transformation.
Finally, Professor Stiglitz cautions against liberalizing
financial and capital markets as advised by the Washington Consensus.
He reminds us that African countries that followed the
Washington Consensus like so many faithful converts paid the price for not
thinking on their own feet. To quote Professor Stiglitz: “Credit to small
and medium sized enterprises went down. More broadly, credit to productive
investments went down. … Not surprising, the result was that growth
was lower in countries that liberalized.”
The countries that succeeded were those in East
Asia; unlike African countries, they regulated financial markets
in the interest of their development.
Professor Stiglitz says that the Washington Consensus is an
ideology. He has a term for it: he calls it “free market fundamentalism.”
It was “ignored in Asia” but “has inflicted a high cost on developing
countries, especially in Africa.” He says the
Crisis of 2008 provides a moment for reflection, on the key importance of the
financial sector, and of how ideology—flawed ideas about markets—led to a
global disaster.”
The lessons are two-fold: first, “more than better
regulation is required”; second. “the government must take an active role in
providing development finance.”
I am not an economist, but I have been forced to learn its
basics to defend myself in the academy and the world. Like you, I live in
a world where policy discourse has been dominated – I should say colonized – by
economists whose vision is limited to the economy. Professor Stiglitz
derides this as “free market fundamentalism” and I agree with him.
Like fundamentalist generals who think that the conduct,
outcome and consequence of war is determined by what happens on the
battlefield, the thought of fundamentalist economists not only revolves around
the market but is also limited by it. Just as war is too important an
activity to be left to generals, the material welfare of peoples is also too
important to be left to economists alone.
I salute the work Professor Stiglitz has done to show the
havoc caused by what he calls “free market fundamentalists.” But I have a
critique. I have already argued that his definition of the problem as
that of “market failure” is inadequate. I will now argue that, In light
of the challenge we face today, his response to the problem is also too limited.
To illustrate how deep and pervasive this crisis is, I would
like to sketch some key developments starting with the Clinton years. Let us begin with the
collapse of the Soviet Union. In the
1990s, the Clinton administration urged on Russia
what it called a “shock therapy,” a cocktail of recipes first perfected in
African countries in the 1980s, and baptized as Structural Adjustment by the
Washington Consensus.
That policy practically destroyed essential consumer
industries, from pharmaceuticals to poultry, and led to mass poverty in Russia.
Fully backed by the Clinton
administration, Yeltsin and his fellow conspirators were happy to implement
this “shock therapy” as a way to acquire property at the expense of democracy.
In the words of a moderate Russian paper, Literary Gazette,
the “shock therapy” turned Russia
into “a zone of catastrophe.”
We may note that none of the architects of this policy in
the Clinton
administration – neither Larry Summers, nor Jeffrey Sachs nor former President
Clinton himself – has every publicly apologized for this.
My second example is more current. The Eurozone was
created as a single currency for Europe but without constituting Europe as a democratic polity.
The result was that monetary policy was formulated outside
the framework of democracy. The states in Europe
have done to their own people what the Washington Consensus did to African
peoples in the 80s. Unelected governments rule Europe;
the EU ruling phalanx is not accountable to any one.
By all technical standards, what is taking shape in Europe is dictatorship. Not only are essential mechanisms
of democratic systems being eroded or discarded, democracy is rapidly losing
credibility. For the third time in a century, Germany
is looking to turn Europe into its backyard.
Germany
is now achieving with banks what it failed to achieve with tanks in World War I
and World War II. It is even more interesting that it is Germany that should now propose a democratic
solution to the crisis of the Eurozone, calling for a political unification of Europe.
Historically, capitalism – and the market – have been kept
in check by democracy. Both the Russian and the European cases show us
what happens when you do away with the democratic process in the interest of
economic efficiency.
In both the Russian and the European cases – and one could
multiply examples – the problem has not been the absence of state activism.
If anything, states have reinforced the havoc wreaked by market forces on
society. Society is the missing term in the state-market equation that
has defined the debate on “market failure” among economists.
The tendency of the market, like that of the state, is to
devour society. The challenge is to defend society against these twin
forces.
Here is my point: The antidote to the market was never
the state but democracy. Not the state but a democratic political order
has contained the worst fallout from capitalism over the last few centuries.
The real custodian of a democratic order was never the state
but society. The question we are facing today is not just that of market
failure but of an all-round political failure: the financialization of
capitalism is leading to the collapse of the democratic order. The problem
was best defined by the Occupy Wall Street movement in the US: it is the 99% against the 1%.
Thus my third question: does not this empirical
acknowledgement need to be translated into a theoretical insight? Does it
not call for a revised theoretical apparatus: one beyond a focus on “market
failure”; one that does not limit the frame to the market and the state; one
that is more interdisciplinary and more focused on the intersection of the
economic, the political, and the social, both to illuminate the depth of the
crisis we are faced with today and to shift focus from the state and the market
to society?
IV. Lessons for us in Uganda, in East Africa
and in Africa
I have little doubt that the audience here wants us to go
beyond questions of economic theory, beyond a discussion of the global crisis.
This audience would like some discussion of the Ugandan crisis. I
will ask my fourth and last question on behalf of the audience: What are the
lessons for Uganda, East
Africa and Africa?
My first observation is that the Ugandan crisis is not
really exceptional if you look at the rest of the world. In his more
public and less academic observations, Professor Stiglitz has remarked on the
depths of the problem in “much of the world”. Take an example from 2007
when Professor Stiglitz wrote of globalization on Beppe Grillo’s Blog in 2007:
"For much of the world, globalization as it has been
managed seems like a pact with the devil. A few people in the country become
wealthier; GDP statistics, for what they are worth, look better, but ways of
life and basic values are threatened. ... This is not how it has to
be."
It would be a shame if this audience is to walk away from
Professor Stiglitz’s lecture with a message that the problem is just one of “market
failure” and the solution is a robust state that regulates markets and provides
development finance. Is the lesson of the Structural Adjustment era simply that
we need strong states to defend ourselves from the Washington Consensus?
Or does the experience of the SAP era also raise a second
question: What happens if developing countries are forced to push open their
markets before they have stable, democratic institutions to protect their
citizens? Should we be surprised that the result is something worse than
crony capitalism, worse than private corruption, whereby those in the state use
their positions to privatize social resources and stifle societal opposition?
Social activists in Uganda increasingly argue that the
state and the market are not opposites; they have come together in a diabolical
pact. Like in the US
where the state feeds the greed of the banks, the state in Uganda has
become the springboard of systemic corruption. The use of eminent domain
clause to appropriate land – from tropical rain forests to primary and
secondary schools – is done in the name of development.
Even parliamentarians who discuss the oil issue complain,
almost on a daily basis, that instead of leveling the information field, the
state uses all its resources to keep information secret and muzzle public
discussion on how public resources are used. The question is simple: what
happens if it is the state, and not just market forces, that hoards
information?
I want to broaden our focus to the East African community.
The political class in Africa is weak.
Often, its vision is clouded by a singleminded preoccupation with the
question of it own political survival. The result is a singular lack of
imagination, marked by a tendency to borrow ‘solutions’ from the West.
The AU named itself after the EU. The East African
Community adopted the European process hook, line and sinker: first a common
market, then a common currency, before any political arrangement. Here is
my question: Will the pursuit of this European recipe – introducing a
common East African currency without first creating a common political
framework for East Africa, without first
solving the question of sovereignty, whether through a federation or a
confederation – not invite a Europe-type crisis?
V. Conclusion
Let me conclude with two observations, one theoretical, the
second political.
When I was a graduate student, my economics professor asked
me to read a great postwar classic, Karl Polanyi’s The Great Transformation.
Polanyi was the first to point out that self-regulating markets are bound
to lead to a social catastrophe. Polanyi began with the observation that
the market is much older than capitalism.
It has been around for thousands of years. Markets
have coexisted with different kinds of economies and societies: capitalist,
feudal, slave-owning, communal, all of them. The distinguishing feature
of all previous eras has been that societies have always regulated markets, set
limit on their operation, and thus set limits on both private accumulation and
widespread impoverishment. Only with capitalism has the market wrenched
itself free of society.
A consequence of this development has been gross enrichment
of a few alongside mass poverty. A corollary of this process, we may say,
is that regulation is now seen as the task of the state, and not of society.
That solution is rapidly turning into a problem. Not
only has the market wrenched itself free from society, so is the state trying
to do the same. Not only do market forces threaten to colonize society,
the state too threatens to devour society. Free markets are not a
solution for poverty; they are one cause of modern poverty. State
sovereignty is not a guarantor of freedom; it threatens to undermine social
freedom.
The challenge is not how the state can regulate the market,
but how society can regulate both the state and the market.
I thank you.
References:
Stephen E. Cohen, “The Soviet Union’s Afterlife,” The
Nation, New York,
January 9/16, 2012
Karl Polanyi, The Great Transformation.
Robert Pollin
Department of Economics and
Political Economy Research Institute University of Massachusetts-Amherst,
Review (for Challenge Magazine) of The Roaring Nineties: A New History of the
World’s Most Prosperous Decade by Joseph E. Stiglitz, Political Economy
Research Institute, Working paper No. 83, 2004
Joseph Stiglitz, “Market Failures in the Financial System:
Implications for Financial Sector Policies, especially in Developing
Countries,” Joseph Mubiru Lecture, Bank of Uganda, Munyonyo Conference Centre,
Kampala, July 16, 2012, 28 pp.
Market failures in the financial system
Publish Date: Jul 18, 2012
It intermediates between savers and investors, providing capital to new and growing businesses. When it does its functions well, economies prosper, when it does its jobs poorly, economies and societies suffer.
Unfortunately, there is a growing sentiment that in recent years, banks in many countries—including the US and Europe—didn’t do their job well. The resulting losses are enormous—in terms GDP alone, in the trillions of dollars.
Regulators have been blamed, but mainly for not doing their job, of preventing these abuses. For this, there is no excuse: There have been periods (notably in the decades beginning in the mid-30s) in which regulation worked.
But then interests and ideology combined to push an agenda of deregulation and liberalization. Even before that ideology had become fashionable in the 1980s, economic science had explained why markets in general and financial markets in particular were, on their own, neither efficient not stable, a perspective reinforced by a wealth of historical experience.
Recent scandals throughout the world entailing bankers engaged in predatory and discriminatory lending, abusive credit card practices, market manipulation (the libor rate) and a host of other misdeeds has led to the view that there is a moral deficiency, a culture of corruption.
In each instance, the bankers attempt to claim that there were a few rogue actors (a few rotten apples); but the pervasiveness and frequency of the problems reinforces the view that there is a systemic problem.
While banking may attract those that are more motivated by financial rewards, than say the intrinsic rewards of public service or the pursuit of knowledge, the fact is that my students who went into banking did not seem that different from the others, to have this evident lack of a moral compass.
The answer, it would seem, is that there have been incentives and opportunities that have led to this kind of behavior.
And this then is the key point: we need regulations to oversee the financial sector, to make sure that private incentives are better aligned with social returns. This alignment hasn’t happened on its own, and it won’t happen on its own. It is only when private rewards equal social returns that markets are efficient, that Adam Smith’s “invisible hand” has any chance of working.
When I was chair of President Clinton’s Council of Economic Advisers, I was charged with reviewing the regulatory structure of the US financial system, asking what we hoped from our regulatory system, why we had these regulations, and could we design a system that achieved its objectives more efficiently. Later, as chief economist of the World Bank, I confronted similar issues.
Much of this was before the rash of scandals over the past decade. But even then there was a concern that banks weren’t necessarily doing what they should be doing.
Too many seemed more focused on investing in government bonds or speculating on foreign exchange than providing loans to local enterprises. More recently, they have found it easier to make money lending to consumers than to businesses.
Too many seemed to be enjoying the good life, taking in deposits at low interest rates, and relending the money to government at high interest rates. IMF policies, insisting that these banking activities be undertaken by the private sector, but, in the fight to fight inflation, leading to high interest rates, meant a transfer of large sums of money to the private banking sector.
These transfers could not be justified in terms of a distinctive service that they provided, but were rather evidence that markets weren’t working the way they should—with competition the spread between the lending rate (especially to the government) and the deposit rate should have been minimal.
With the near collapse of the global economy in 2008, there is an increased awareness of the importance of market failures, those circumstances in which markets fail to act in an efficient and stable manner, in the way that they are supposed to. I already suggested one of the fundamental reasons for these market failures—a misalignment between private rewards and social returns.
Nowhere are market failures more pervasive or more important, with such profound consequences for our economic system, than in the financial sector. In this lecture, I will provide taxonomy of these market failures and how regulatory and other policies can help overcome them.
But rather than providing a simple list of the key market failures—from imperfections of competition, asymmetries of information, incompleteness of markets, coordination failures, externalities—I approach the subject from the perspective of the taxonomy of interventions—the key areas in which governments, all over the world, have intervened in financial markets, to help make them serve the public interest better.
Safety and soundness
Depositors put their money into banks, in the expectation that they will be able to get their money out when they need it. Banks, of course, don’t leave the money idle.
They know that they can “use” the money to earn returns—and in a competitive world, those returns (less charges for managing the money) are returned to the depositors. There are two difficulties:
(a) the bank may not invest the money well, in which case there won’t be any money to repay the depositors; or
(b) the best use of the money is long term investments, but individuals may demand their money before the projects reach maturation.
Other investors may not have confidence in the project(s) the bank has undertaken, and so it cannot sell the project for what it had hoped to get. This latter problem is known as that of maturity transformation—short term funding for long term projects.
The inability to get funds is referred to as a liquidity problem, as distinct from the solvency problem (where the bank has, say, squandered the money).
But the distinction between liquidity and solvency is somewhat artificial: if everyone could agree on the value of the long term project, presumably there would be someone to whom the bank could sell the project to reap the long term returns now.
(There is a macro-economic liquidity problem, where the Central Bank has so tightened credit, in an unexpected way, that there is simply no one able to purchase the project. Our focus now, however, is primarily on a liquidity problem facing a particular bank, not the financial system as a whole.)
The incentive, in the absence of oversight, for banks to take individuals money and not repay is enormous.
Even when there is not outright fraud, if they lend to their friends and family at low rates, without adequate scrutiny, they can walk off with profits when the gambles pay off, with depositors bearing the losses when things don’t go well.
The problems are even worse for undercapitalized banks, for the franchise value—the value of the firm as an ongoing enterprise—is then diminished, and it has incentives to gamble on resurrection.
Ensuring safety and soundness
There are several ways that regulators can deal with these problems. Unfortunately, banks have often used their political influence to ensure that regulators do not use the full set of possible instruments, so that the problems of safety and soundness appear even in seemingly well-regulated banking systems—as we as evident in the US, when the entire banking system faced collapse in 2008. Here is a short list of some of the key regulations
(a) They shut down banks that are undercapitalized; they want to make sure that the owners of the bank have substantial sums at risk, including the franchise value;
(b) They restrict connected lending;
(c) They attempt to ensure that bank owners (and managers) are “reputable”;
(d) They restrict excessive risk taking;
(e) This includes restricting excessive leverage, and impose a variety of other liquidity and capital constraints, and restricting lending practices (e.g. imposing minimum standards for mortgages, for instance on the size of the downpayment, and other restrictions on the form of mortgages)
(f) They restrict the incentive structures of bank officers, so that they do not have incentives for excessive risk taking and excessively short sighted behavior;
(g) They prevent banks from becoming too big to fail, knowing that such banks have an incentive to engage in risk taking, since taxpayers are bearing part of the downside risk
(h) They prevent banks from becoming too intertwined to fail, or too correlated to fail, knowing too that banks have an incentive to do so, knowing that then taxpayers will have to bail them out.
(i) They insist on transparency and good accounting standards, so that market participants—and not just regulators—can exercise oversight, and make judgments about the viability of the institutions.
(j) They attempt to restrict conflicts of interest (such as those which arise when the same bank issues securities and makes loans), realizing that this both undermines confidence in capital markets and increases the likelihood of bad lending.
From this brief list of what regulators could do it is apparent that many regulators don’t use the full panoply of instruments. For instance, in the US, regulators have been lax in capital requirements, not adequately restricted incentive schemes, done little about the too-big-to-fail banks, have allowed banks to use flawed accounting standards, and have not insisted on adequate transparency.
Consider, for instance, the issue of transparency in CDS’s and other derivatives. Not even the ECB was able to forecast the consequences of what would happen in the event of a deep restructuring of Greek debt, or to assess the differences that might arise from a voluntary or involuntary restructuring.
It was lack of transparency that contributed to the freezing of the interbank market after the collapse of Lehman brothers, and it is lack of transparency that is contributing to the weaknesses in that market today.
Because it is so hard to control the behavior of banks directly (it’s hard for regulators and supervisors to observe and monitor every transaction), regulators have regulated not just organizational and individual incentives, but the structure of the banking system itself.
The separation of commercial and investment banking helps avoid some conflicts of interest, and avoids contaminating commercial banks (which are supposed to invest the savings of ordinary households safely) with the risk taking culture of investment banks.
Moreover, at least in the United States, after the repeal of the Glass-Steagall Act which separated the two kinds of banks, concentration in the banking system increased rapidly; the problem of too-big-to fail became much worse.
Market failures and safety and soundness
The underlying market failure is, of course, that of imperfect information. If depositors could perfectly observe (and evaluate) what the bank was doing with its money, then the moment it did something that might put the depositors’ money at risk, they could and presumably would withdraw their money; and this would exercise effective discipline over bank officers. But bank officers know that they have considerable discretion.
Similarly, the ‘agency” problem that arises from distorted bank manager incentives arises because the bank (and ultimately, the banks depositors, shareholders, and bondholders) can’t perfectly monitor what the bank managers are doing, the riskiness of the loans, etc.
What can be monitored (if only imperfectly) are things like leverage, connected lending, and most importantly, the incentive structures. (In my judgment, it is scandalous that regulators allowed banks to provide their officers with -compensation schemes that incentivized excessive risk taking—and didn’t even succeed in increasing shareholder value.)
That is also why it is important to ensure that there are appropriate organizational incentives; for if there are perverse organizational incentives, there is a risk that such incentives will get translated in subtle ways into the behavior of managers. That’s why there has to be regulations preventing the growth of too-big-to fail banks.
But there are two further subtle market failures. The first is that because of the implicit guarantee for too big to fail banks, they are subsidized, and they grow at the expense of others not necessarily because they are more efficient or provide better services, but because they are more subsidized.
Unless government takes action to offset this implicit subsidy, financial markets will be distorted.
The same thing is true, of course, in looking at banks from different countries, as is increasingly becoming apparent in Europe. A country’s banks are backed by its government, but the strength of that implicit guarantee depends on the fiscal strength of the government. American banks are thus the beneficiary of a larger implicit subsidy (an implicit subsidy that was made explicit in 2008-2009).
Within Europe, German banks are the beneficiary of a differential subsidy. Inevitably, there is no level playing field.
If we are to have an efficient financial sector, governments have to “level out” this playing field. This is especially important because there are biases in the patterns of lending of large banks and of foreign banks (which I will discuss at greater length later.)
Large banks tend to lend less to small and medium sized enterprises, and more to governments and large enterprises; and so to for foreign banks—except that, in addition, they have a preference for firms from their own country or multi-nationals more generally.
Because with banking crises, there will inevitably be bailouts, and markets know this, there is an incentive, as we have noted, for banks to become too intertwined and too correlated to fail. They have an incentive to create systemic risk problems. (And these incentives are exhibited at the individual level as well: when managers follow the herd, and the herd fails, they are not likely to be punished.
“Everyone else did it.” “Who could have foreseen these problems?” These are the refrains that one repeatedly hears. (See Nalebuff and Stiglitz, 1983).
Size is easy to observe. “Intertwining” is more difficult. Correlated behavior is often hard to observe, but even when observed, harder to prevent.
While intertwining is difficult to observe, some of the worse forms—those that impose the most systemic risk-- can easily be stopped: the buying and selling of CDS’s on each other.
Correlated (herd) behavior characterized the stampede into subprime mortgages in the last decade, and into Latin American loans in the 80s, and into East Asia in the 90s. The creation of universal banks has, I believe, made matters worse, as had the increasing prevalence of short term investors. All are pursuing the same short sighted goals and all face the same opportunity set.
Creating a more diverse “financial eco-system”—with some firms specializing in housing, others in insurance, others in long term investments, others in commerce—has not only benefits from specialization (returns to scale in gathering and processing information), but in creating institutions that have different objectives and face different constraints and opportunities. While there is some loss of diversity within the institution, there is still full diversification within the economy, and it is that which matters most.
Investors who want to diversify their risks still can. While the probability of some firms going bankrupt might increase, the probability of systemic risk would decrease. The system as a whole would become more resilient, especially to large shocks (e.g. macro-economic disturbances.)
But the information market failures are multi-layered. Not only can’t regulators monitor banks well, neither can shareholders and depositors. Nor is the record of the credit rating agencies very credible. The notion of capital market discipline is largely a myth.
If a regulator who has carefully pored over the banks books and its loan portfolio can say that a bank is in fine health, and a few weeks later, it goes bankrupt, how can shareholders and depositors hope to appraise what is going on. Non-transparent derivatives have made a difficult matter impossible: without knowing not only the holdings of these securities, but also the counterparties, and the balance sheets of the counterparties, there is no way of really assessing the bank’s position.
Even apart from this, accounting standards in many countries have made matters difficult: in the US, even non-performing mortgages don’t have to be marked down, as the US, in an attempt to avoid bank recapitalization, switched from marking to market to marking to hope—hope that perhaps these mortgages would eventually be repaid.
Mark to market accounting has been confused in other ways: a bank that faces a higher risk of bankruptcy receives an uplift to its valuation, because of the decrease in the value of its debt. An accounting system designed to help equity and bond investors appraise the value of these securities has been misused by regulators.
There are some important corollaries of these information and agency problems, which I simply list here:
1. Good corporate governance needs to be part of the regulatory regime—ensuring, for instance, that banks are not run just for the interests of managers, and that shareholders have say-in—pay.
2. But regulators can’t rely on good corporate governance. There have to be restrictions particularly on the design of incentive pay systems.
3. There is a need for better accounting systems, and more careful thought about the appropriate use of accounting systems and their interaction with the regulatory system. Mark to market accounting can on its own be pro-cyclical, which is why it has to be accompanied by macro-prudential regulations.
Leverage
A major reform in the aftermath of the crisis is to require banks to have more capital. They have resisted this. I suspect, though, that not even Basle III has gone far enough.
The proclivity of banks to take on excessive leverage has been a subject of extensive discussion. There is one obvious reason: the higher the leverage, the greater the implicit “bail-out subsidy.” But this is not, of course, the banks’ argument. They seem to believe that it is more efficient for banks to have highly leveraged.
The most important insight of modern financial economics is that of Modigliani and Miller (for which they received the Nobel Prize). They observed that when a firm takes on more leverage, the equity becomes riskier, and thus the price of equity should rise, so much so that (ignoring taxes) the value of the firm remains unchanged, even though the cost of debt is seemingly lower than the cost of equity.
There is no such thing as a free lunch. They also ignored bankruptcy costs. But with bankruptcy costs, as banks take on more leverage, there is a higher probability to default—a fact that should have been obvious before the crisis.
There is some debate about the rationality of capital markets: do investors really realize this? If they don’t, then bank managers can take advantage of investors’ ignorance of risk by increasing leverage.
But of course, what is going on here is really a hidden redistribution—from uninformed investors, who don’t realize the risk that they’ve undertaken, to the banks’ managers. But overall societal efficiency is reduced, because of the additional expected bankruptcy costs.
Macro-economic stability
The objective of safety and soundness is closely related to that of systemic risk and macro-economic stability. When a small bank fails, we may be concerned about the depositors, but the ripple effects will be limited. But when a large bank fails—or a large number of medium sized banks fail—it has macro-economic effects.
The deepest and longest lasting downturns are related to bank failures (though sometimes the causality runs the other way—deep and long downturns will inevitably be reflected in bank failures.)
By the same token, if the government has to bail out a small bank, the costs are easily managed. The costs of systemic crises can be huge, amounting to a significant fraction of a country’s annual GDP.
That is why it is especially important for the government to prevent systemic risk. Interestingly, before the crisis, few governments paid attention to this issue, though a few academics (Allen and Gale, 2001, Greenwald and Stiglitz, 2003) had done so.
I’ve already discussed one of the policies that is essential for preventing systemic failures: avoiding too-big-to fail, too-correlated-to fail and too intertwined to fail banks.
But macro-prudential regulation is designed to ensure that the financial system does not contribute to cyclical fluctuations, and in so doing, reduces the risk of systemic failure. Credit bubbles have been a major source of economic volatility since the beginning of capitalism. An increase in credit fuels a bubble, which increases the value of collateral, which leads to further credit expansion.
Banking regulations, strictly enforced, have often contributed to this credit cycle. When the bubble breaks, bank net worth is greatly reduced, and banks are forced to contract their credit greatly. The contraction of credit contributes to the economic downturn.
There is an obvious way to try to tame the credit cycle: when the economy is in a boom, increase capital requirements, which dampens the availability of credit. Tightening mortgage standards directly dampens a housing bubble; increasing margin requirements may dampen a stock market bubble.
Market failure
The key market failure is that there is an important extenality from the collapse of the financial system. Just like toxic wastes pollute the environment, America’s toxic mortgages polluted the world’s financial system. Obviously, individual banks don’t take this into account in deciding how much leverage to undertake, or how intertwined to become with other banks.
In fact, they want to maximize the externality—because that increases the likelihood of a bail-out.
There are other market failures that are essential to understanding the necessity of government intervention. If equity markets worked well, a bank that lost capital as a result of a bad event (the collapse of the real estate market) could easily recapitalize itself.
But, because of information asymmetries, equity markets do not work well. There is what Greenwald and I call “equity rationing.” The cost of raising new equity is so high that banks would rather contract than pay the cost—the dilution of shareholder value—unless they are ordered to do so by the government (and even then, it may not be possible.)
Access to credit and allocation of credit
A major responsibility of the financial sector is to allocate credit. From a social point of view, what matters is social return. From the bank’s perspective, the question is what returns it can extract, related to the interest rates it can charge and the likelihood of default.
Or that would be the case if (a) managers’ interests were well-aligned with that of the bank; and (b) the bank bore all the costs of failure. As we noted earlier, there are major failure in both individual and organizational incentives that lead to excessive risk taking and short sighted behavior.
But it similarly can lead to more lending for speculative real estate and consumption than for productive investments in, say, manufacturing or employment generation, or to increase productivity in agriculture.
The gap between social and private returns has always been there, but it may be getting worse, and may be worse in developing countries.
Development entails large developmental externalities, which banks typically don’t take into account. Moreover, development requires long term credit, but banks have traditionally focused on short term lending (which can itself be explained by information imperfections). But changes in corporate governance in recent years have encouraged them to be even more short sighted.
Foreign banks’ interests and information exacerbates these problems. Key to job creation to employment and enterprise creation in developing countries is lending to SME’s, but that requires highly specific information, in which foreign banks may be at a comparative disadvantage.
Recent empirical evidence shows that foreign banks do indeed lend (proportionately) less to SME’s (and this in turn helps explain why developing countries where foreign banks play la more important role have grown more slowly.)
The problems are further exacerbated by the greater concern that foreign banks may have that the governments may expropriate or take other actions that will reduce their capacity to “extract rents” from the country. This induces the firm to have an even shorter term horizon.
There are three ways of dealing with this problem. The government may impose constraints on lending—minimums (e.g. to underserved sectors, like agriculture and SME’s) or maximum (real estate). It can use such restraints to reduce consumer lending.
It can attempt to lower returns on categories of lending where social returns are less than private returns (as in speculative real estate) by imposing higher capital adequacy requirements or deposit insurance rates.
Thirdly, the government can set up specialized development banks. In the hey-day of the Washington Consensus, countries were told that development banks would inevitably fail. Banking was an activity to be reserved to the private sector. What has happened since then has forced a rethinking.
On the one hand, America’s private banks performed dismally—the waste of resources, now in the trillions of dollars, is greater than that of any democratic government. On the other hand, Brazil has had an extraordinary successful development bank, which has played an important role in that country’s economic success. It is a bank that is twice the size of the World Bank.
The failures of some development banks provides a note of caution. But appropriately structured, with appropriate oversight, development banks can be an important source of needed long term finance.
Market failure
It is clear, looking at patterns of lending, in both developed and developing countries, that prevalent patterns of lending do not reflect social returns. Too much goes to land speculation, too little to job and enterprise creation.
In general, in credit markets, private and social returns are not well aligned. The lender only cares about the returns he is able to appropriate. The dollar returns from speculation may exceed those to real investment, and if so, that’s where the money will go. Moreover, banks, like other private sector firms, are short sighted; development, on the other hand, is long term.
It is hard for government to micro-manage lending, and that’s why interventions have to be limited to the broad interventions described above. But it is important to note that there may be social as well as narrowly defined economic objectives.
Banks, on their own, for instance may engage in discrimination and red-lining (not lending in certain areas). Regulators may ban this kind of discrimination, and impose stiff penalties when they detect it.
Consumer Protection
In almost all countries, governments have taken an important role in protecting both depositors and borrowers.
Protecting Depositors
Depositors have to be protected, because there is no way that the typical depositor can be sure of the financial position of a bank—as we noted earlier, even the regulators haven’t been able to do a very good job.
Deposit insurance is motivated by three market failures: First, an information market failure: because of asymmetries of information, banks may take advantage of unwary depositors, putting their money into investments that are risky. Without deposit insurance, there would be a lack of confidence in the banking system, particularly in difficult times.
This leads then to the second market failure: this lack of confidence in banks could lead to a run on the banks, with large systemic effects. (There are other contractual designs, e.g. a mutual fund, which would not (likely) give rise to such runs. But there are distinct advantages to the debt contract. Runs are, of course, related to the problem of maturity transformation, that the bank’s assets and liabilities differ in maturity.
This too in principle could be avoided, but only at a high cost. Long term investments yield higher returns, but short term deposits provide some discipline against the bank’s misuse of funds. (Rey-Stiglitz (2012)).
But some critics of deposit insurance argue that deposit insurance actually creates its own moral hazard problem: depositors don’t have any incentive to monitor banks, and thus banks have an incentive to undertake risky lending, which allows them to pay higher interest rates.
But, as we have noted, there is in fact no way that depositors could effectively monitor banks; but even if they could, monitoring is a public good. It is inefficient to have every individual engaged in monitoring. Monitoring should be done by a public body.
Regulators have to be attentive to the incentive effects that insurance gives rise to—just as any insurance company needs to be attentive to moral hazard. In this case, it should look carefully at any firm paying high deposit rates: is it doing so because its transactions costs are lower, i.e. because it is more efficient, or because it is undertaking more risk.
Given the frequency with which banks fail, we now have a much better understanding of some of the factors that contribute, and again, regulators need to be attentive to these: excessive risk taking, excessive leverage, lack of transparency—and perhaps most importantly, excessive expansion (especially in the aftermath of market liberalization initiatives.)
(The failure of the credit agencies has demonstrated the deficiencies in the purported alternative, private sector solution. Elsewhere, I have argued that these failures are not only repeated, but inherent.)
Protecting borrowers
Banks around the world have learned that they can greatly enhance their profits by engaging in predatory lending and abusive credit card practices. This is not the place to provide a catalogue of the ingenuity that the banks have demonstrated.
Banks often try to be deceptive about the interest rate and fees charged, including overdraft fees, and there has been an ongoing battle in the United States and other countries to elicit greater transparency, and to ensure that the fees are disclosed in a way that the borrower understands.
A potentially important step forward in the United States was the creation of a financial products safety commission, to ascertain whether the financial products being sold do what is claimed that they do, whether they have “disguised” risks—are they safe for human consumption.
Other countries should follow this example, but developing countries should perhaps go further. Many of the new financial products are simply designed either to circumvent regulations or to fleece borrowers. Making markets simple will also make them work better—in a more competitive way.
Thus, it makes a great deal of sense to standardize mortgages, e.g. fixed rate mortgages of 20 or 30 year duration, or at least mortgages with fixed payments and of long duration.
Governments may go further by redesigning parts of the financial system. The Danish mortgage bond system has worked well for that country for more than 200 years—far better than the American system, which has failed massively twice in under two decades, and remains dysfunctional, with the government now underwriting almost all mortgages.
Competition
There is one more important reason for government intervention in the financial sector: to maintain competition. In many countries, the banking sector is highly concentrated, and even when it is not, banks often act in ways which suggest tacit collusion. It is hard to explain otherwise the persistently high returns—far in excess of competitive levels.
Occasionally, we see evidence of strongly anti-competitive behavior. The credit card companies Visa and Mastercard (originally owned by the banks) set the interchange fees (the fees they charge merchants) at an extra-ordinarily high level, far in excess of the competitive level.
It should take but a fraction of a penny to move money from the consumer’s bank account into that of the merchant; it simply entails the movement of a few electrons. Yet the banks and the credit card companies charged amounts that were ten, a hundred, a thousand times more.
One grocery company was, in effect, splitting its profits almost 50-50 with the credit card company on credit card sales: for moving a few electrons, the banks/credit card company got as much the grocery store got for all of its efforts in managing the complex operation of buying and selling fresh food.
The credit card companies were, in effect, levying a tax on all of these transactions, a tax which however did not go for public purpose, but simply to enrich the coffers of the banks and the other owners of the credit card companies.
The scandals that marked the beginning of the century involving the bank analysts—touting stocks that they knew were “dogs”—was so universal, and the cooperation they exhibited in a system that took advantage of uninformed investors to enrich themselves and corporate CEO’s so pervasive that it is natural to suspect that there may have been tacit or explicit collusion. So too in the case of the recent LIBOR scandal.
The remedy here is straightforward: stricter enforcement of the anti-trust laws (and stricter enforcement, with more criminal penalties for the fraudulent and manipulative behavior that they have used to enhance their profits.) Breaking up the too big to fail banks too might create more competition.
Financial and capital market liberalization and market failure: A Review
I want to end my lecture with a brief discussion of capital and financial market liberalization—a reassessment based on the analysis of market failures in the financial market.
An important part of the advice given to developing countries (e.g. by the Washington Consensus) was that they should liberalize their financial and capital markets, removing a whole variety of restrictions, including on foreign investment, sectoral allocations, etc.
Regulation was stripped to minimal instruments, namely capital adequacy requirements. Universal banks were encouraged (with restrictions on securities transactions removed) and development banks discouraged.
The promise was that this approach would deepen financial markets, this would make financial markets more competitive, transactions costs would fall, funds for development would increase, and growth would increase. To put it mildly, this approach has failed in achieving the promised outcomes.
Recent research has shown that those countries that took financial market liberalization further did get more foreign banks, but none of the ultimate or even intermediate objectives were achieved. Spreads in banking did not come down.
Credit to small and medium sized enterprises went down. More broadly, credit to productive investments went down. More credit went to consumers and housing. One more, somewhat unexpected effect: large flows of money from the banking sector abroad, a repatriation of profits, the rents of the financial sector, larger, in Africa, for instance, than ODA and FDI. Not surprising, the result was that growth was lower in countries that liberalized.
Capital market liberalization too has not brought the benefits that were promised—it didn’t bring higher growth, but it did bring more volatility.
The “liberalizers” also advocated moving away from bank financing to “markets.” The increased reliance on markets (as opposed to bank finance) too didn’t work out as the markets advocated expected.
I wrote, more than twenty years ago, that I was worried that the advocates of securitization had overestimated the benefits: they hadn’t taken into account how the lack of accountability that would arise from securitization would lead to poorer mortgages (the moral hazard problem) ; they had underestimated the extent to which the returns would be correlated, so they had overestimated the benefits of diversification; and they had underestimated the risk of price declines.
All of these problems were evident in the failure leading to the Great Recession.
Of course, for many developing countries, markets didn’t develop in the way that its advocates hoped. The reason should have been clear: providing capital to new enterprises is information intensive, and markets are not good at doing this, at least with respect to small and medium sized enterprises.
Until very recently, even in the United States, only a small fraction of new investment is financed through “markets.”
It was foolish to think that thick and efficient markets would develop quickly in most developing countries. Rather, the focus should have been on strengthening the banking system, its ability to assess risks, and to provide credit to sustain growth and employment.
The countries in East Asia that were successful used financial markets to advance their development. They realized that unrestrained financial markets are neither efficient nor stable—and do not advance the country’s development agenda. They were aware of the dangers of financial repression, the problems that arise when there are, for instance, very negative real returns. They engaged in what I call financial restraint.
They governed and shaped financial markets, and especially the banks, so that they served the country, and not the other way around. They realized that resources were scarce, and they couldn’t be squandered on real estate speculation or fancy cars. The country needed real investments if it was to grow.
The Washington Consensus ideology has inflicted a high cost on developing countries, especially in Africa. In Asia, to a large extent, it was ignored. Latin America was richer. For two decades, it contributed to their slow growth, but they managed to keep poverty from soaring.
The Crisis of 2008 provides a moment for reflection, on the key importance of the financial sector, and of how ideology—flawed ideas about markets—led to a global disaster. In this lecture, I have attempted to review some of the lessons. It is clear that we needed better regulation.
But more than better regulation is required. The government must take an active role in providing development finance.
I have attempted to provide some insights into why financial markets so often fail—fail to serve the economy in the way that they are supposed to—and into what kinds of policies can mitigate those failures. America is a rich country, but even it cannot really afford losses of the magnitude that its failed financial sector has inflicted.
For developing countries there is no choice: they have to make sure that their financial system serves their development agenda.
