Arnold Kling  

Stiglitz the Omniscient

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Joseph Stiglitz writes,

there have been more than one hundred financial crises worldwide in the last 30 years or so. Here in the United States alone, we have had the S&L crisis in 1989, the dot-com/WorldCom/Enron problems of the early years of this decade, and now the subprime-morphing-into-the-beyond-subprime collapse. In addition to these national problems, there were regional troubles--real-estate crises fed by excessive lending in Texas and the Southwest in the mid-'80s, and in California and New England in the early '90s. In each of these instances, financial markets failed to do what they were supposed to do in allocating capital and managing risk.

When writing a novel, one of the things you have to decide is point of view. If you focus on one character, your point of view might be limited to what that character sees.

One point of view for the author to take is that of an omniscient observer. As you read, you know that the author knows what is coming (you keep getting hints) and understands all sorts of things that the characters are innocent about.

Stiglitz always writes as the omniscient observer. He knows exactly what should have been done to prevent or solve each of the 100 financial crises that he cites.

This omniscient-observer vantage point has its limits. It does not convey the uncertainty and trade-offs that policymakers face in real time. For example, as the housing bubble was inflating, there were not many Congressional voices raised against lending to first-time homebuyers.

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COMMENTS (11 to date)
Les writes:

It is amusing to see crises such as the S&L and subprime crises claimed to be "financial market failures."

In both these crises - and many others, I'm sure - the credit goes to government for ill-considered policies that led to moral hazard and economic disaster.

ed writes:

Enron etc. was bad, but it wasn't an economy-wide "crisis".

The S&L "crisis" was basically caused by BAD government regulation, as Les points out.

The current "crisis," though, looks to me to be primarily a failure of the market. The rating agencies look particularly bad. But that doesn't mean that regulators could do better.

manuelg writes:

> In each of these instances, financial markets failed to do what they were supposed to do in allocating capital and managing risk.

Nuts. The market is supposed to be a fully functioning time-machine? Any mechanism, public or private or government or non-government, that could have "pulled the trigger" and stopped most of the alleged "one hundred financial crises worldwide" would have other-worldly, spooky properties.

Also, if the US housing bubble was so transparently a bubble before it burst, why didn't the rest of the world "pull the trigger", take the short term loss, and pull their money out of the US financial system? Because, they were happy with the profits, while they kept rolling in.

Is Stiglitz selling something that lets you avoid the downside risk, while still enjoying the fullness of the upside reward? If not, then nuts.

Glen writes:

Well, I guess you can call it 'market failure' when the market doesn't generate the results you want. Also, don't most government policies tend to turn the targeted market into kind of a Ponzi scheme?

I agree with Glen! Stiglitz certainly thinks he knows all of the answers to all problems - that is the typical attitude of bureaucrat.

bwv writes:

I think much of this comes down to agency problems in the financial markets, i.e. actions that are rational with opm (other peoples money) that would not be rational with your own. Executives in all large corporations are skilled at creating free options for themselves, and that is all these financial crises came down to - some fundamental story creates an opportunity for players to create free options (the option arm for the house-flipper, the origination fee for the mortgage broker shopping around a loan for a bad credit risk, the year-end bonus of the Wall Street exec for packaging together a bunch of crap into a CDO, etc.) The opportunities for short-term gains from the free options distort the markets because the participants are all rationally following their incentives. If the downside for a CEO of a major investment bank is an eight or nine figure severance package if he blows up the company and he has even more participation on the upside, what do people expect will happen? Executive compensation in many cases has become a free, in-the-money straddle.

Tim writes:

Anyone can point out the problems after the fact. That's one of the advantages of's 20/20.

If Stiglitz wanted to really impress us, he would roll out all of his editorials, papers, etc. written prior to each collapse where he (a) told us how it would unravel, (b) what we could do to short-circuit the unravelling, (c) how to fix it if we don't solve the problem before it unravels.

Then we could properly praise him for his omniscience.

Chuck writes:

I think the point is that many of these crises were caused by deregulation in expectation that a free-er market is going to work better.

Then, it doesn't.

I know it is a point of faith that somehow it was Fannie/Freddie's mis-regulation that put the housing world off the tracks, but I've yet to see something remotely convincing in that regard. (To be clear, I'm not saying that Freddie/Fannie were well run, etc, I don't really know).

What I have seen is that Frannie had rules in place that did not permit them to buy the kind of loans that have been the most trouble. Which seems plausible to me, since those loans all got bundled out into CDO's and all that other garbage, rather than being held by Frannie.

There were many necessary components to this failure:

1) the ratings agencies were paid by the wrong people - they were paid by people issuing bonds instead of by people buying bonds, and they simply lied about the quality of the bonds they were rating.
2) 'responsible parties' at banks simply ignored housing prices rising far past impossibly high levels.
3) entire swaths of the mortgage industry made loans that were laughably un-repayable.
4) furthermore, there is problems throughout the credit industry - credit cards, auto loans, etc, etc. The banking industry has simply 'boomed' on promiscuous credit, and now it is busting.

We've seen boom and bust in markets for ever. Why can't we accept that boom and bust is a natural part of markets (at least markets that involve human being) and support reasonable measures to minimize that when we can?

Furthermore, why is the boom/bust nature of markets not sufficient evidence that markets are far from the efficient mechanisms it sounds like they are portrayed as?

fundamentalist writes:

Stiglitz is simply dishonest. The tiny amount of "deregulation" that took place was the equivalent of loosening a dozen among thousands of ropes that hold the market down. He knows that the market has been tied by thousands of state regulations and assaulted by a drunken Fed. His is a case of blaming the victim for rape. At best he accuses someone who is bound, gagged, blugeoned and drugged by the state for not aiding the rape victim.

Kim writes:

Wow! fundamentalist, you sound very angry. I can think of soooo many metaphors right now. "Hindsight is 20/20", "What goes up must come down", etc. However, everything works through cycles. Did anyone NOT expect the bubble to burst of the housing market? It was just a matter of when and how bad was it going to be.

fundamentalist writes:

Kim: "Wow! fundamentalist, you sound very angry."

Actually I'm not. Just curious, what about my post made you think that?

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