Stiglitz Weighs In on US Meltdown

I was wondering when we'd hear from Joe Stiglitz on the US economic meltdown. Fortunately that happened today in the form of an opinion piece from the Nobel Prize winning US economist. As expected, Stiglitz brings some much needed clarity and insight to the problems:

"...the rescue plan that was just defeated was far better than what the Bush administration originally proposed. But its basic approach remained critically flawed. First, it relied – once again – on trickle-down economics: somehow, throwing enough money at Wall Street would trickle down to Main Street, helping ordinary workers and homeowners. Trickle-down economics almost never works, and it is no more likely to work this time.

Moreover, the plan assumed that the fundamental problem was one of confidence. That is no doubt part of the problem; but the underlying problem is that financial markets made some very bad loans. There was a housing bubble, and loans were made on the basis of inflated prices.

Even if a bail-out plan were implemented quickly – which appears increasingly unlikely – there would be some credit contraction. The US economy has been sustained by a consumption boom fueled by excessive borrowing, and that will be curtailed. States and localities are cutting back expenditures. Household balance sheets are weaker. An economic slowdown will exacerbate all our financial problems.

We could do more with less money. The holes in financial institutions' balance sheets should be filled in a transparent way. The Scandinavian countries showed the way two decades ago. Warren Buffet showed another way, in providing equity to Goldman Sachs. By issuing preferred shares with warrants (options), one reduces the public's downside risk and ensures that they participate in some of the upside potential.

This approach is not only proven, but it also provides both the incentives and wherewithal needed for lending to resume. It avoids the hopeless task of trying to value millions of complex mortgages and the even more complex financial products in which they are embedded, and it deals with the "lemons" problem – the government gets stuck with the worst or most overpriced assets. Finally, it can be done far more quickly.

At the same time, several steps can be taken to reduce foreclosures. First, housing can be made more affordable for poor and middle-income Americans by converting the mortgage deduction into a cashable tax credit. The government effectively pays 50% of the mortgage interest and real estate taxes for upper-income Americans, yet does nothing for the poor. Second, bankruptcy reform is needed to allow homeowners to write down the value of their homes and stay in their houses. Third, government could assume part of a mortgage, taking advantage of its lower borrowing costs.

Investment banks and credit rating agencies believed in financial alchemy – the notion that significant value could be created by slicing and dicing securities. The new view is that real value can be created by un-slicing and un-dicing – pulling these assets out of the financial system and turning them over to the government. But that requires overpaying for the assets, benefiting only the banks.

In the end, there is a high likelihood that if such a plan is ultimately adopted, American taxpayers will be left on the hook. In environmental economics, there is a basic principle, called "the polluter pays principle." It is a matter of both equity and efficiency. Wall Street has polluted the economy with toxic mortgages. It should pay for the cleanup.

There is a growing consensus among economists that any bail-out based on Paulson's plan won't work. If so, the huge increase in the national debt and the realisation that even $700bn is not enough to rescue the US economy will erode confidence further and aggravate its weakness.
But it is impossible for politicians to do nothing in such a crisis. So we may have to pray that an agreement crafted with the toxic mix of special interests, misguided economics, and right-wing ideologies that produced the crisis can somehow produce a rescue plan that works – or whose failure doesn't do too much damage."

I think there's enormous merit in Stiglitz' approach. You don't buy bad mortgages. They stay with the outfits that were stupid and greedy enough to buy them. Instead you inject government money into those same companies to restore their liquidity, taking back a preferred share position that means the taxpayers' interest stands above all others. The taxpayers' money has to be repaid - out of the good mortgages if it comes right down to it - before the other investors see a dime.