To Cure the Economy

Joseph E. Stiglitz


NEW YORK – As the economic slump that began in 2007 persists, the question on everyone’s minds is obvious: Why? Unless we have a better understanding of the causes of the crisis, we can’t implement an effective recovery strategy. And, so far, we have neither.

We were told that this was a financial crisis, so governments on both sides of the Atlantic focused on the banks. Stimulus programs were sold as being a temporary palliative, needed to bridge the gap until the financial sector recovered and private lending resumed. But, while bank profitability and bonuses have returned, lending has not recovered, despite record-low long- and short-term interest rates.

The banks claim that lending remains constrained by a shortage of creditworthy borrowers, owing to the sick economy. And key data indicate that they are at least partly right. After all, large enterprises are sitting on a few trillion dollars in cash, so money is not what is holding them back from investing and hiring. Some, perhaps many, small businesses are, however, in a very different position; strapped for funds, they can’t grow, and many are being forced to contract.

Still, overall, business investment – excluding construction – has returned to 10% of GDP (from 10.6% before the crisis). With so much excess capacity in real estate, confidence will not recover to its pre-crisis level anytime soon, regardless of what is done to the banking sector.

The financial sector’s inexcusable recklessness, given free rein by mindless deregulation, was the obvious precipitating factor of the crisis. The legacy of excess real-estate capacity and over-leveraged households makes recovery all the more difficult.

But the economy was very sick before the crisis; the housing bubble merely papered over its weaknesses. Without bubble-supported consumption, there would have been a massive shortfall in aggregate demand. Instead, the personal saving rate plunged to 1%, and the bottom 80% of Americans were spending, every year, roughly 110% of their income. Even if the financial sector were fully repaired, and even if these profligate Americans hadn’t learned a lesson about the importance of saving, their consumption would be limited to 100% of their income. So anyone who talks about the consumercoming back” – even after deleveraging – is living in a fantasy world.

Fixing the financial sector was necessary for economic recovery, but far from sufficient. To understand what needs to be done, we have to understand the economy’s problems before the crisis hit.

First, America and the world were victims of their own success. Rapid productivity increases in manufacturing had outpaced growth in demand, which meant that manufacturing employment decreased. Labor had to shift to services.

The problem is analogous to that which arose at the beginning of the twentieth century, when rapid productivity growth in agriculture forced labor to move from rural areas to urban manufacturing centers. With a decline in farm income in excess of 50% from 1929 to 1932, one might have anticipated massive migration. But workers were “trapped” in the rural sector: they didn’t have the resources to move, and their declining incomes so weakened aggregate demand that urban/manufacturing unemployment soared.

For America and Europe, the need for labor to move out of manufacturing is compounded by shifting comparative advantage: not only is the total number of manufacturing jobs limited globally, but a smaller share of those jobs will be local.

Globalization has been one, but only one, of the factors contributing to the second key problemgrowing inequality. Shifting income from those who would spend it to those who won’t lowers aggregate demand. By the same token, soaring energy prices shifted purchasing power from the United States and Europe to oil exporters, who, recognizing the volatility of energy prices, rightly saved much of this income.

The final problem contributing to weakness in global aggregate demand was emerging markets’ massive buildup of foreign-exchange reserves – partly motivated by the mismanagement of the 1997-98 East Asia crisis by the International Monetary Fund and the US Treasury. Countries recognized that without reserves, they risked losing their economic sovereignty. Many said, “Never again.” But, while the buildup of reserves – currently around $7.6 trillion in emerging and developing economiesprotected them, money going into reserves was money not spent.

Where are we today in addressing these underlying problems? To take the last one first, those countries that built up large reserves were able to weather the economic crisis better, so the incentive to accumulate reserves is even stronger.

Similarly, while bankers have regained their bonuses, workers are seeing their wages eroded and their hours diminished, further widening the income gap. Moreover, the US has not shaken off its dependence on oil. With oil prices back above $100 a barrel this summer – and still highmoney is once again being transferred to the oil-exporting countries. And the structural transformation of the advanced economies, implied by the need to move labor out of traditional manufacturing branches, is occurring very slowly.

Government plays a central role in financing the services that people want, like education and health care. And government-financed education and training, in particular, will be critical in restoring competitiveness in Europe and the US. But both have chosen fiscal austerity, all but ensuring that their economies’ transitions will be slow.

The prescription for what ails the global economy follows directly from the diagnosis: strong government expenditures, aimed at facilitating restructuring, promoting energy conservation, and reducing inequality, and a reform of the global financial system that creates an alternative to the buildup of reserves.

Eventually, the world’s leaders – and the voters who elect them – will come to recognize this. As growth prospects continue to weaken, they will have no choice. But how much pain will we have to bear in the meantime?

Joseph E. Stiglitz is University Professor at Columbia University, a Nobel laureate in economics, and the author of Freefall: Free Markets and the Sinking of the Global Economy.
Copyright: Project Syndicate, 2011.

October 2, 2011 8:02 pm

Why business despairs of Obama

David Bromley
Take a deep breath. The industrialised world, America included, seems stuck in one of those horror movies, where the monster, thought to be slain, morphs into something even more scary. The fear is that a double-dip, or worse, is now upon us. Those who might help us escape are now being held back by the anti-business policies of President Barack Obama.

Mr Obama’s administration predicted a V-shaped recovery, based on the historical experience of the 1970s and 1980s. Not this time. The $4,000bn of fiscal and monetary stimulus produced less than $1,000bn in growth. Gross domestic product is now running at about 1.8 per cent this year but two-thirds of this will come from growth in business inventories, not final sales.
Consumers are clearly not willing to generate these new sales. The University of Michigan’s confidence numbers have fallen to levels 20 per cent or more below earlier recessions. The numbers now match the drops seen after the Iran hostage crisis, Iraq’s invasion of Kuwait and the collapse of Lehman Brothers. No wonder that in the 14 quarters since the beginning of 2008, growth in consumption adjusted for inflation averaged just 0.5 per cent, the longest period of weakness since the end of the second world war.

This weak record on growth is proving disastrous for ordinary Americans. Per capita income remains below its 2006 level, while wage-based incomes are declining. It is little surprise, then, that adjusting for inflation, retail sales last month contracted at nearly a 5 per cent annual pace, while the proportion of Americans living in poverty soared. This is a modern day depression, only this time soup lines have been replaced by unemployment cheques.

Facing these challenges, businesses are trying to enhance productivity, not create jobs. Polls show that business leaders are growing increasingly pessimistic. In the past six months a third of companies have delayed or cancelled plans for capital spending.

Of course, none of this was helped by a government that lost credibility by predicting that its recovery programmes would bring the jobless rate down and growth up. This was the beginning of the yawning credibility gap between the Obama’s administration and business. The gap is being aggravated by Mr Obama’s recent sharp turn to the left.

This resort to divisive populismlaying the blame on “fat cats” and pillorying the president’s favourite villains – “millionaires and billionaires” – is exactly the wrong approach. It seeds the suspicion that the administration is more interested in campaigning and undermines the confidence that business needs if it is to invest in the face of new regulations, healthcare costs and an increased bureaucracy.

Businesses sense that the administration no longer understands how this perceived hostility saps the animal spirits required for taking risks on expansions and start-ups.

When governments are shown to be powerless or incompetent, ordinary people suddenly realise that their elected officials have neither the understanding, the political power and sometimes not even the will to do what is necessary. In part this is because they are scared of voter backlash. At that point despair and alienation takes control of public opinion and they concentrate on preserving what little of their long-term prospects and savings they can.

This dismal point we have reached today. Confidence in the US government has fallen so far that a recent Gallup poll found only 26 per cent approving the president’s management of the economy. And there is a sense that there are not too many effective tools left in the toolbox of the government.

Many Americans are puzzled as to why hiring has remained so weak during what seemed to be a recovery. Now there is a national sense of anxiety over an economy that seems to be on the verge of another economic contraction and may send the unemployment rate to levels not seen since the 1930’s. What is to be done?

The most promising policy option and one that enjoys bipartisan support is to broaden the tax base by eliminating the special tax earmarks and provisions built in over time, and using the funds raised to lower tax rates for both businesses and individuals. This offers the best opportunity to rekindle economic confidence and growth as well as opening businesses to increased hiring without jeopardizing any further our fiscal imbalances.

Only a programme this dramatic would transform the current loss of confidence that has provoked conservative hiring practices by the American business community, who had not imagined a recession this severe was a realistic possibility.

This is perhaps the only programme the Republicans will buy into, for their focus is on reducing the national deficit. They are absolutely opposed to tax increases and without them the Democrats will never agree to any cost reductions in programmes. In other words, this is a formula for political gridlock.

Of course, it is the weak economy, very high unemployment rate and very low confidence in the administration that represent the most important political opportunity for the Republicans to drive the Democrats out of office next year.

The era of frugality is back. Today it is not a stock market crash or a crash in residential real estate but a crash in confidence that will constrain the effectiveness of public policy and have long-lasting impacts on the consumer and the economy. The historic American optimism has dramatically eroded. The great American dream is no longer a house in the suburbs. It is a secure job, but almost any job will do.
The writer is editor-in-chief of US News & World Report and chairman, chief executive and co-founder of Boston Properties
Copyright The Financial Times Limited 2011.

October 2, 2011 10:20 pm

Tighter rules on capital: Bankers versus Basel

The industry is preparing a full-on assault on a deal regulators see as the best way to prevent future financial meltdown – and the question is whether the accord will be left with enough teeth
Jamie Dimon
Vehement complaint: Jamie Dimon of JPMorgan Chase argues that the Basel III plan to impose extra requirements on the biggest financial groups is economically and philosophically wrong

Two weeks ago , the simmering battle over how to make the financial system safer turned nasty.

On one side: Jamie Dimon, chief executive of JPMorgan Chase, one of the world’s largest banks and one of the few institutions to emerge from the financial crisis relatively unscathed. On the other: the silver-tongued Mark Carney, formerly of Goldman Sachs, now governor of the Bank of Canada. He too was speaking from a position of strength because the banks he supervised survived the turmoil of 2008 in good shape.

The setting for the showdown was the National Archives building in Washington, the grand neoclassical home of the American constitution, the Bill of Rights and a copy of the Magna Carta. But the document that sparked the fight was a much more modern affairone that curtails freedom rather than guarantees it.

Basel III, named after the Swiss-based international committee of regulators that issued the rules, is a complex package of reforms designed to make banks more resilient and less likely to need taxpayer rescue in future. It forces all lenders – particularly the largest – to build up buffers of equity, cash and liquid assets to protect themselves against unexpected losses or another market crisis.

According to some of the 30 or so people gathered in a meeting room at the archives, Mr Dimon lambasted Mr Carneycomplaining vehemently that the Basel committee’s plan to subject his own and other large institutions to even higher capital requirements than those faced by smaller peers was ill-thought-out and economically and philosophically wrong. He also insisted that some provisions discriminated against US banks.

European bankers were left wide-eyed by the outburst but many of them have been launching their own, usually quieter, attacks on Basel III from the other side of the Atlantic. They argue that parts of the liquidity and capital rules unfairly penalise their universal banking model, which combines both insurance and banking in a single group and is found mainly in France and the Benelux countries.

The ill-tempered exchange in Washington was more than a lone instance. Behind complaints about level playing fields, the entire industry is warming up for a full-on assault on the Basel deal, which was hailed last year as the single most important step towards preventing the next financial Armageddon. The next year or so could determine whether that accord will be left with enough teeth to reshape banking fundamentally – or cease to be worth the paper it is written on.

“The large banks are seeking to undo the relatively moderate progress that has been made on improving regulation thus far, using the very economic crisis they helped trigger as an excuse,” says Sony Kapoor, managing director of Re-Define, a financial think-tank.

As the bankers see it, they are preserving the already shaky world economy and the global financial system. Forcing them to hold more capital and low-yielding liquidity will, they say, make many of their business lines unprofitable and drive up costs for customers. The Institute of International Finance, an industry group, estimates that the reform package could push up borrowing costs by 3.5 per cent, cut global output by 3.2 per cent by 2015 and cost 7.5m jobs.

Regulators see it differently. To them, the real threat comes from an unreconstructed industry still addicted to short-term funding that can dry up at the drop of a hat. They also argue that profits remain too dependent on risky derivatives and proprietary trading. Their “impact studies” suggest that enforcing a build-up of capital would trim growth only mildly in the short term. Any pain would be far outweighed over the long run by the benefits of stability.

“The crisis is akin to a heart attack for banks. Some people would like to go on smoking and drinking, but what we are asking banks to do is have the same market discipline as non-banks,” says Tom Huertas, who represented the UK in many of the Basel talks.

Supervisors are also adamant that forcing banks to shore up their capital over time, rather than paying out earnings in staff bonuses and shareholder dividends, is the correct thing to do.

The Basel committee, a group of regulators from 27 large economies, late last month reaffirmed its plans to slap a surcharge on big international banks, forcing them to hold extra capital on top of the global minimums set last year. That means JPMorgan, for example, must hold top-quality capital equal to 9.5 per cent of its assets weighted for risk – whereby the riskiest loans need to carry more capital against them than safer assets.

“If some institutions feel pressure today, it is because they have done too little for too long, rather than because they are being asked to do too much, too soon,” Mr Carney said in a speech two days after Mr Dimon’s verbal onslaught.

Too bad, says the industry, but no surprise. Mr Carney was just target practice. The only hope, according to several senior executives, is that politicians will ride to the rescue.

Bankers now want to reopen, or at least delay the implementation of, last year’s overall Basel III deal, arguing that to adopt it would be to kill off the nascent economic recovery. With world leaders scheduled to endorse the big bank surcharge at a meeting of the Group of 20 leading nations in Cannes in November, they sense that time is running out.

At the same time, lobbyists are making the case to legislators and national regulators in charge of implementing Basel III in each country that changes are needed to make sure their local banks are not disadvantaged.

On this level, the banks are starting to score some successes. In Europe, the draft version of the regulation that would enshrine Basel III in law includes a clause that would make it easier for French banks to count the capital in their insurance subsidiaries towards their overall total. With the market already suspicious about French banks’ resilience, the change would help them keep their capital ratios – an important measure of bank strength high.

The EU draft also appears to gut the “leverage ratio” – a measure backed by the US and UK that seeks to keep banks from bulking up their total assets in relation to their equity. High leverage has been cited as an important reason for the 2008 collapse of Lehman Brothers.

The cap on insurance subsidiaries, meanwhile, formed part of a grand trade to tighten up the definition of what could be counted as capitalagain a response to problems uncovered in the financial crisis, when many items previously classified as capital turned out to be useless. If the French win their special category, then what, observers ask, is to stop the Germans, Japanese and Americans from doing the same?

The various moves have alarmed some global banks that would prefer a single set of consistent standards to a raft of local rules, even if some are more favourable. “It opens the door to everyone else cheating too,” says one weary industry lobbyist.

American banks are also starting to gain local traction with some of their complaints particularly Mr Dimon’s allegation that European lenders are manipulating the way they measure risk in order to reduce their capital requirements.

Under Basel rules, the amount of capital a bank needs depends on the size and riskiness of its assets – and banks are allowed to use their own internal models to measure risk. Yet the difference between a group’s risk-weighted assets and its unweighted total assets varies considerably by institution and by country, suggesting that some may be cutting their capital needs by understating their risk.

Mr Dimon and other US bankers are convinced their European counterparts are cheating, a charge that has drawn some sympathy from Barney Frank, the senior Democrat on the House of Representatives financial services committee. “It’s plausible to me that there could be some manipulation on the risk-weighting,” he says. He fears some European countries might weaken the regulation in practice by undervaluing risk.

On this gripe, US banks have not only the likes of Mr Frank behind them but also a number of regulators. Andrea Enria, head of the European Banking Authority, expressed concern at the variation in risk-weights that EU banks used during stress tests that produced results the market branded laughably positive. A UK pilot project to test bank models also found enormous differences.

Last week the Basel committee announced plans to conduct a formal study of the issue, to decide once and for all whether some banks and their regulators are fiddling the figures. It is also to put out report cards highlighting when countries put the rules in place and when they depart from them.

Bank complaints about the liquidity rules are also starting to bear fruit. The eurozone sovereign debt crisis has certainly boosted the argument that the definition of safe assets – which included the bonds of countries such as Greeceneeds a fundamental rethink. The Basel group has agreed to speed up planned adjustments to the way this requirement is calculated to “provide greater market certainty”. The changes could please banks by broadening the kind of assets they can count and reducing the overall amount they have to hold.

Time is the bankers’ best hope. If the global economy is still reeling next year and in 2013, governments may be more willing to take the fetters off the big banks. If Barack Obama fails to win a second presidential term in 2012, a Republican White House may be more sympathetic.

For now, however, most regulators and politicians are still in favour of standing up to the banks, particularly on the fundamental question of capital requirements. Mr Frank, for instance, has no interest in ditching the capital surcharge that so angers Mr Dimon – and insists he does not want the rules to be watered down, just made fair.

The global redrawing of financial regulation should, he says, be “a race to the top and not the bottom”.


There are four key elements to the Basel III deal aimed at making banks more able to survive unexpected losses or funding problems and less likely to need taxpayer rescue.

The rules will be fully phased in by 2019.

Capital Banks must have top quality (“core tier one”) capital equal to 7 per cent of assets, adjusted for risk, or face restrictions on paying bonuses and dividends.

Surcharge The biggestsystemically important financial institutions” have to carry an extra 1-2.5 per cent in capital, for a total of up to 9.5 per cent of risk-weighted assets.

Liquidity Banks have to keep enough cash and easy-to-sell assets to survive a 30-day market crisis.

Leverage The ratio of core tier one capital to a bank’s total assets, with no risk adjustment, may not exceed 3 per cent.
Copyright The Financial Times Limited 2011.