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Farewell to the Invisible Hand?A Global Financial System for the Twenty-First Century
Joseph E. Stiglitz2010 David Finch LectureMelbourneJuly 28, 2010
Adam Smith’s Invisible Hand
Perhaps the most important insight of modern economics:Individuals (and firms) in the pursuit of their own self-interest are led, as if by an invisible hand, to the well-being of society
The End of theSmithianEra?
But no one believes that America’s bankers, in their ruthless pursuit of their own self-interest (aka as greed) resulted in the well-being of societyNot only did they bring about a global financial crisisBut they engage in predatory pricingAnti-competitive practices led to super-normal profitsModern technology allows for the creation of an electronic payments system: they suppressed the creation of this system, imposing in effect a tax on every debit and credit transaction—with proceeds going to enrich their coffers, not to enhance public welfare
Failure to perform key societal roles
Financial markets are essential to the well-functioning of a modern economySupposed to allocate capital, manage risk, and run a payments mechanismAnd an efficient financial system does this at low costAmerica’s financial system misallocated capital, created risk, didn’t create the 21stcentury payments mechanism that modern technology could have supportedBut nonetheless imposed huge costs on the rest of society40% of all corporate profits before the crisisIncommensurate with the benefits that they generatedThough there was a small part of America’s financial sector that was doing a stupendous job—the venture capital sectorA sector that is now weak because of the misdeeds of the rest of the sector
What does modern economic theory have to say?
A quarter century before the crisis modern economic theory had argued that Adam Smith was wrongThe reason that the invisible hand often seems invisible is that it’s not thereWhenever there is imperfection (asymmetric information) or incomplete risk markets—that is always—markets are not Pareto efficientEven taking into account the costs of information and of creating and running markets, there are interventions that could improve the well-being of all citizens
These ideas are central to understanding financial markets
Information (and information asymmetries) are at the center of financial markets“Agency problems”: decision makers interests are different from those on whose behalf they are suppose to be actingBank officials did well, even as shareholders and bondholders lostProblems of corporate governance worse in the US than in some other countriesA chain of agency problemsInvestors were off pension funds acting on behalf of retirees
Illustrates pointIncentive structures were designed to induce excess risk taking and short sighted behaviorDidn’t even distinguish between those who increased profits by increasing “beta” (more risk) and “alpha” (better performance)Didn’t distinguish between high returns because market was doing well and “beating the market”Inconsistent with “efficient” incentive systemsMost of those in the financial system didn’t understand thisBut some may have been deliberate attempt to take advantage of lack of understanding of investors
In many cases, compensation based on stock optionsTreating them as if they were manna from heavenNot dilution as shareholder valueResisted efforts even to make this transparentEnhanced incentives for bad informationWhich would increase shareholder value in the short run—though not in the long runA market economy cannot run well with such distorted incentives
Main justification for regulation—a failure of financial system has consequences for othersThe entire economic system was put at riskThe US had policymakers and regulators who did not understand these limitations of marketsThought that markets were self-regulatingStripped away regulations—that had provided the only period free of financial crises in the history of modern economiesAnd did not adopt new regulations for changing financial sector (derivatives)We had regulators who did not believe in regulation
Greenspan’s Mea Culpa
Had thought banks would have managed risk betterIgnored distorted incentive structures/agency problemsIgnored risk posed by too big to fail banksIgnored externalities—didn’t seem to understand why we have regulation in the first place
Financial Innovation
Sector prided itself on innovationBut innovation was mostly directed at circumventing regulation, taxes, and accounting standardsHard to identify an innovation that led to a more productive economyEasy to identify innovations that led to huge risksBorne by taxpayersNew risk products didn’t even help Americans manage the risk of their most important asset—their homeActually, increased risk—which is why so many are losing their homesThere were alternatives—but they have consistently resisted these “good” innovations
Not a surprise
Incentives led to excessive risk takingIncentives le to predatory lendingDid not have incentives to innovate in ways that would improve the well-being of societyFundamental problem: misalignment of social and private returnsADAM SMITH’S INVISIBLE HAND ONLY WORKS WHEN SOCIAL AND PRIVATE BENEFITS/COSTS ARE WELL ALIGNED
Understanding functions of global financial marketsUnderstanding why financial markets on their own are likely not to succeed in fulfilling their rolesAnd how government can effectively intervene
Principles of Regulation
TransparencyIncentivesRestricting incentive structures that led to excessive risk takingDealing with the problem of too-big-to fail banksConflicts of interest—rife in sectorBut because of problems of corporate governance, providing the right incentives may not go far enough
Restricting risk takingBasic insight of Modigliani and Miller was that increasing leverage did not bring societal benefits—but could increase costsBankers and regulators didn’t understand thisCollateral based lending and capital adequacy standards can act as automaticdestabilizersNeed for macro-prudential regulation
Played big role in crisis--$180 billion AIG bailout—did more to create risk than to manage riskNon-transparentUnderwritten in effect by taxpayersGiven preference in bankruptcyNew bill recognizes the principle/risks of allowing banks to write derivativesBut banks got major exceptions
Regulating Behaviors and Structures
GlassSteagall—separated out investment and commercial bankingDifferent culturesConflicts of interestJoining two together exacerbated problems of too big to fail (and too big to manage) banksVolcker rule (restricting proprietary trading) was an attempt to deal with these problemsBut again, Congress put in large exceptions
Consumer/investor protection
Financial product safety commissionBanks sold products that were not safe for human consumptionPredatory lendingPredatory credit card practices
Resolution authority
Intended to facilitate dealing with problem banksBut when banks are too big to fail, they almost surely will be bailed outIt was fear that motivated not following usual rules of capitalismSocializing losses and privatizing gainsAnd in the next crisis, likelihood that the too big to fail banks (and their shareholders and bondholders will again be bailed out)Failure to deal with the too big to fail banks critical failure of US legislation
Creating a new global financial regulatory system
Finance is global, and without a global regulatory system, there is risk of arbitrage, circumventionBut power of banking lobby, especially in US, too strong to get adequate regulationThough Goldman Sachs, through its various exposed practices proved best lobbyist for reformsEach country has a responsibility to protect its own citizens and economyGlobal coordination being used as a delaying deviceEach country adopt its own protective rulesInevitably will weaken financial market globalizationIceland and U.S. toxic mortgages show risks of relying of the regulation of othersThen a period of harmonization
Creating a more stable global financial system
Better regulation is only part of the answerTaxing speculative activityConsistent with principle that it is better to tax externalities (like pollution) than good things (like work and savings)In fact, some parts of the financial sector has received massive subsidies, bailouts, that have contributed to its become over bloatedBetter systems of managing global riskDeveloping countries still have to bear brunt of exchange rate and interest rate riskFailed to transfer risk from those less able to those more able to manage it
A new global reserve system
Makes little sense for global financial system to be so dependent on the currency of a single countryEspecially in a multi-polar worldAnd especially as confidence in U.S. economy is weakeningCurrent system contributes to instability, weak aggregate demand, and is unfairEvery year, hundreds of billions of dollars are set aside as “precautionary savings” (reserves)Poor countries are lending to the U.S. at low interest rates (and sometimes borrowing back at much higher interest rates)
Increasing support for a new global reserve systemUN CommissionChina, other countries holding reservesWell designed system could also be used to finance climate change, meet other global needsOld idea—Keynes advocated it 75 years agoBut it is an idea whose time has come
Devising a better system of global financial governance
Global financial institutions have failedEven the financial stability forum—created to prevent another crisisChanging the name to financial stability board may not fully solve the problemG-20 is not inclusive and lacks political legitimacyWhat is needed: a global economic coordinating councilBased on principles of representationSmall enough to reach decisions, large enough to have diverse circumstances of different countries adequately representedG-20 may evolve in this direction
Silver Lining on Global Crisis
Has brought home the need for global cooperation—and the risks of failureIn the aftermath of the Great Depression and World War II, current international institutions were createdThese are now not up to the tasks posed by globalization todayThe hope is that we will seize this opportunity





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