The forces behind the fiscal meltdown

By Chuck Leddy
Globe Correspondent / January 25, 2010

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Winner of the Nobel Prize for economics and a specialist on globalization, Joseph Stiglitz suggests that the US financial crisis that triggered the present global recession could have been avoided.

Stiglitz strongly rejects the idea that the crisis “just happened’’: It occurred because of conscious decisions by stakeholders, including bankers, regulators, investors, and debt-laden consumers. During the bubble, these groups failed to accurately assess the risk, Stiglitz argues, because they chose not to.

Stiglitz points to the acceptance of the idea that unregulated markets are both self-correcting and maximize social good: “Economies need a balance between the role of markets and the role of government . . . America lost that balance’’ with disastrous consequences. Stiglitz says that “financial innovations’’ that grew in a largely unregulated financial sector, from subprime mortgages to credit default swaps, served to maximize bankers’ fees while putting the financial system at risk.

Stiglitz doesn’t scapegoat the bankers or investors who pushed financial risk to its limits and beyond, but instead blames “fundamental flaws in the capitalist system.’’ Then he meticulously and brilliantly describes these flaws. For example, banks and their managers were compensated according to the fees they generated. Underwriting bad (“innovative’’) loans and then transferring the risk through securitization - grouping the loans into pools, then selling shares in those pools to investors - generated massive profits and huge bonuses for years.

Stiglitz says that incentives promoted “the quantity of mortgages originated, not the quality.’’ The game was simple, boost the number of mortgages by watering down lending standards (e.g., “no income, no problem’’) and then move the garbage down the river by securitizing the risk.

This amounted to a game of musical chairs in which the last one standing when the music stopped lost. And the last one standing was not the bonus-laden bankers or the negligent regulators, notes Stiglitz, it was the American taxpayer. The banks took such great risks, Stiglitz asserts, partly because they knew that if they lost, the government would bail them out.

Stiglitz calls it the triumph of “Corporate Welfarism American-style,’’ which he describes as “the privatizing of gains and the socializing of losses.’’ The author asks some basic and provocative questions, such as why massive bailouts focused on banks instead of homeowners who are now awash in debt.

Much of Stiglitz’s most passionate criticism is aimed at the Obama administration and his economic team, which includes several Bush holdovers. He accuses the president of “muddling through’’ the crisis with no clear reformist vision. No game-changing financial regulations have been instituted; the “too big to fail’’ banks are even bigger today; and there’s no policy to break them up to reduce systemic risk.

“Freefall’’ is a must-read for anyone seeking to understand the roots of the financial crisis. Stiglitz brilliantly analyzes the economic reasons behind the banking collapse, but he goes much further, digging down to the wrongheaded national faith in the power of free markets to regulate themselves and provide wealth for all. Stiglitz seeks a return to a more balanced market economy that limits financial risk in the name of both the public interest and systemic stability. But as corporate bailouts continue and Main Street remains awash in debt and unemployment, Stiglitz is justifiably pessimistic about the prospects for meaningful change.

Chuck Leddy is a freelance writer who lives in Dorchester.

FREEFALL: America, Free Markets, and the Sinking of the World Economy
By Joseph Stiglitz
Norton, 361 pp., $27.95