Two Nobel Laureates on the Crisis

by Dollars and Sense

First, 2001 winner and regular Guardian correspondent Joseph Stiiglitz. Note especially the difference between the way the sainted Buffet and the US taxpayer are being treated....

Paulson tries again

Unlike the UK plan, the revamped American bail-out puts banks first and taxpayers second

Joseph Stiglitz
The Guardian

Gordon Brown has won plaudits over recent days for inspiring the turnaround in Hank Paulson's thinking that saw him progress from his "cash for trash" plan - derided by almost every economist, and many respected financiers - to a capital injection approach. The international pressure brought to bear on America may indeed have contributed to Paulson's volte-face. But Paulson figured he could reshape the UK approach in a way that was even better for America's banks than his original cash strategy. The fact that US taxpayers might get trashed in the process is simply part of the collateral damage that has been a hallmark of the Bush administration.

Will this bail-out be enough? We don't know. The banks have engaged in such non-transparency that not even they really know the shape they are in. Every day there are more foreclosures - Paulson's plan did little about that. That means new holes in the balance sheets are being opened up as old holes get filled. There is a consensus that our economic downturn will get worse, much worse; and in every economic downturn, bankruptcies go up. So even if the banks had exercised prudent lending - and we know that many didn't - they would be faced with more losses.

Britain showed at least that it still believed in some sort of system of accountability: heads of banks resigned. Nothing like this in the US. Britain understood that it made no sense to pour money into banks and have them pour out money to shareholders. The US only restricted the banks from increasing their dividends. The Treasury has sought to create a picture for the public of toughness, yet behind the scenes it is busy reassuring the banks not to worry, that it's all part of a show to keep voters and Congress placated. What is clear is that we will not have voting shares. Wall Street will have our money, but we will not have a full say in what should be done with it. A glance at the banks' recent track record of managing risk gives taxpayers every reason to be concerned.

For all the show of toughness, the details suggest the US taxpayer got a raw deal. There is no comparison with the terms that Warren Buffett secured when he provided capital to Goldman Sachs. Buffett got a warrant - the right to buy in the future at a price that was even below the depressed price at the time. Paulson got for the US a warrant to buy in the future - at whatever the prevailing price at the time. The whole point of the warrant is so we participate in some of the upside, as the economy recovers from the crisis, and as the financial system starts to work.

The Paulson plan responded to Congress's demand to have something like a warrant, but as a matter of form, not substance. Buffett got warrants equal to 100% of the value of what he put in. America's taxpayers got just 15%. Moreover, as George Soros has pointed out, in a few years time, when the economy is recovered, the banks shouldn't need to turn to the government for capital. The government should have issued convertible shares that gave the right to the government to automatically share in the gain in share price.

Whether we were cheated or not, the banks now have our money. The next Congress will have two major tasks ahead. The first is to make sure that if the taxpayer loses on the deal, financial markets pay. The second is designing new regulations and a new regulatory system. Many in Wall Street have said that this should be postponed to a later date. We have a leaky boat, some argue, we need to fix that first. True, but we also know that there are really problems in the steering mechanism (and the captains who steer it) - if we don't fix those, we will crash on some other rocks before getting into port. Why should anyone have confidence in a banking system which has failed so badly, when nothing is being done to affect incentives? Many of those who urge postponing dealing with the reform of regulations really hope that, once the crisis is passed, business will return to usual, and nothing will be done. That's what happened after the last global financial crisis.

There is a hope: the last financial crisis happened in distant regions of the world. Then it was the taxpayers in Thailand, Korea and Indonesia who had to pick up the tab for the financial markets' bad lending; this time it is taxpayers in the US and Europe. They are angry, and well they should be. Hopefully, our democracies are strong enough to overcome the power of money and special interests, and we will prove able to build the new regulatory system that the world needs if we are to have a prosperous and stable global economy in the 21st century.

Joseph E Stiglitz is university professor at Columbia University and recipient of the Nobel memorial prize in economic science in 2001. He was chief economist at the World Bank at the time of the last global financial crisis.

Now, also from The Guardian, Kenneth Arrow, the 1972 winner. He's talking about himself in the first part, and of Stiglitz in the second, and touches onthe theoretical issues that were, ahem, exaggerated and manipulated in the creation of the bubbles we've come to know and love...

Risky business

The root of this financial crisis is the tension between wanting to spread risk and not understanding its consequences

Kenneth Arrow
The Guardian

The current financial crisis, the loss of asset values, the refusal to extend normally-given credit and the great increase in defaults on obligations ranging from individual mortgages to the debts of great investment banks presents, of course, a pressing challenge to the fiscal authorities and central banks to take measures to minimise the consequences. But they also present a challenge to standard economic theory, a challenge all the more important since the development of policies to prevent future financial crises will depend on a deeper understanding of the processes at work.

That economic decisions are made without certain knowledge of the consequences is pretty self-evident. But, although many economists were aware of this elementary fact, there was no systematic analysis of economic uncertainty until about 1950. There have been two developments in the economic theory of uncertainty in the last 60 years, which have had opposite implications for the radical changes in the financial system. One has made explicit and understandable a long tradition that spreading risks among many bearers improves the functioning of the economy. The second is that there are large differences of information among market participants and that these differences are not well handled by market forces. The first point of view tends to argue for the expansion of markets, the second for recognising that they may fail to exist and, if they do come into being, may fail to work for the benefit of the general economic situation.

The value of spreading risks has, of course, been recognized as the basis of conventional insurance as well as the issue of company shares that spread corporate risks widely. The central element of standard economic analysis since the 1870s has been the concept of general economic equilibrium, which, under competitive conditions, leads to an optimal allocation of resources. In the 1950s, it was shown how to incorporate uncertainty into general equilibrium, which suggests, at least, that increasing the number and coverage of risk-bearing instruments would improve the running of the economy. Not only would risks be more efficiently borne, but, more importantly, additional socially valuable risky enterprises would be undertaken. Research showed how derivative securities should be priced, how individuals should choose portfolios to minimise their variability, and how individual contracts, such as mortgages, could be bundled so as to distribute the risks for different parts of the market with different risk tolerances.

The second strand of analysis was a growing recognition of the importance of information in governing reactions to uncertainties. If individuals in the market have different degrees of information, the ability to create securities or engage in other forms of contracts becomes limited; the less informed understand that the more informed will take advantage and react accordingly. This situation was long recognized by insurance companies under such terms as, "moral hazard" (when the insurer cannot tell how well the insured is avoiding risks) and "adverse selection" (when the insurer cannot distinguish among differentially risky insured, so that, at any given premium, the more risky insure themselves most extensively). Economists began to realise that "asymmetric" information was the key to understanding the limits of health insurance and the incentive problems of socialism and then that these concepts found their most important application in financial markets, precisely in the complex securities that the first strand of analysis had called for.

There is obviously much more to the full understanding of the current financial crisis, but the root is this conflict between the genuine social value of increased variety and spread of risk-bearing securities and the limits imposed by the growing difficulty of understanding the underlying risks imposed by growing complexity.

Labels: financial crisis, Henry Paulson, Joseph Stiglitz, Kenneth Arrow, Warren Buffet

 

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10/16/2008 04:25:00 PM