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The risk today is that the new Keynesian doctrines for financial regulation will be used and abused to serve some of the same interests. Have those who pushed deregulation ten years ago learned their lesson? Or will they simply push for cosmetic reforms, asks Joseph Stiglitz.

The Triumphant Return of John Maynard Keynes

8th December 08 - Joseph Stiglitz, The Guatemala Times

We are all Keynesians now. Even the right in the United States has joined the Keynesian camp with unbridled enthusiasm and on a scale that at one time would have been truly unimaginable.

For those of us who claimed some connection to the Keynesian tradition, this is a moment of triumph, after having been left in the wilderness, almost shunned, for more than three decades. At one level, what is happening now is a triumph of reason and evidence over ideology and interests.

Economic theory had long explained why unfettered markets were not self-correcting, why regulation was needed, why there was an important role for government to play in the economy. But many, especially people working in the financial markets, pushed a type of "market fundamentalism." The misguided policies that resulted - pushed by, among others, some members of US President-elect Barack Obama's economic team - had earlier inflicted enormous costs on developing countries. The moment of enlightenment came only when those policies also began inflicting costs on the US and other advanced industrial countries.

Keynes argued not only that markets are not self-correcting, but that in a severe downturn, monetary policy was likely to be ineffective. Fiscal policy was required. But not all fiscal policies are equivalent. In America today, with an overhang of household debt and high uncertainty, tax cuts are likely to be ineffective (as they were in Japan in the 1990's). Much, if not most, of last February's US tax cut went into savings.

With the huge debt left behind by the Bush administration, the US should be especially motivated to get the largest possible stimulation from each dollar spent. The legacy of underinvestment in technology and infrastructure, especially of the green kind, and the growing divide between the rich and the poor, requires congruence between short-run spending and a long-term vision.

That necessitates restructuring both tax and expenditure programs. Lowering taxes on the poor and raising unemployment benefits while simultaneously increasing taxes on the rich can stimulate the economy, reduce the deficit, and reduce inequality. Cutting expenditures on the Iraq war and increasing expenditures on education can simultaneously increase output in the short and long run and reduce the deficit.

Keynes was worried about a liquidity trap - the inability of monetary authorities to induce an increase in the supply of credit in order to raise the level of economic activity. US Federal Reserve Chairman Ben Bernanke has tried hard to avoid having the blame fall on the Fed for deepening this downturn in the way that it is blamed for the Great Depression, famously associated with a contraction of the money supply and the collapse of banks.

And yet one should read history and theory carefully: preserving financial institutions is not an end in itself, but a means to an end. It is the flow of credit that is important, and the reason that the failure of banks during the Great Depression was important is that they were involved in determining creditworthiness; they were the repositories of information necessary for the maintenance of the flow of credit.

But America's financial system has changed dramatically since the 1930's. Many of America's big banks moved out of the "lending" business and into the "moving business." They focused on buying assets, repackaging them, and selling them, while establishing a record of incompetence in assessing risk and screening for creditworthiness. Hundreds of billions have been spent to preserve these dysfunctional institutions.

Nothing has been done even to address their perverse incentive structures, which encourage short-sighted behavior and excessive risk taking. With private rewards so markedly different from social returns, it is no surprise that the pursuit of self-interest (greed) led to such socially destructive consequences. Not even the interests of their own shareholders have been served well.

Meanwhile, too little is being done to help banks that actually do what banks are supposed to do - lend money and assess creditworthiness.

The Federal government has assumed trillions of dollars of liabilities and risks. In rescuing the financial system, no less than in fiscal policy, we need to worry about the "bang for the buck." Otherwise, the deficit - which has doubled in eight years - will soar even more.

In September, there was talk that the government would get back its money, with interest. As the bailout has ballooned, it is increasingly clear that this was merely another example of financial markets mis appraising risk - just as they have done consistently in recent years. The terms of the Bernanke-Paulson bailouts were disadvantageous to taxpayers, and yet remarkably, despite their size, have done little to rekindle lending.

The neo-liberal push for deregulation served some interests well. Financial markets did well through capital market liberalization. Enabling America to sell its risky financial products and engage in speculation all over the world may have served its firms well, even if they imposed large costs on others.

Today, the risk is that the new Keynesian doctrines will be used and abused to serve some of the same interests. Have those who pushed deregulation ten years ago learned their lesson? Or will they simply push for cosmetic reforms - the minimum required to justify the mega-trillion dollar bailouts? Has there been a change of heart, or only a change in strategy? After all, in today's context, the pursuit of Keynesian policies looks even more profitable than the pursuit of market fundamentalism!

Ten years ago, at the time of the Asian financial crisis, there was much discussion of the need to reform the global financial architecture. Little was done. It is imperative that we not just respond adequately to the current crisis, but that we undertake the long-run reforms that will be necessary if we are to create a more stable, more prosperous, and equitable global economy.

Joseph E. Stiglitz, professor of economics at Columbia University, and recipient of the 2001 Nobel Prize in Economics, is co-author, with Linda Bilmes, of The Three Trillion Dollar War: The True Costs of the Iraq Conflict.

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No surprise there. Stiglitz, more than anyone on the Washington scene, was the biggest fly in the ointment of "free-market fundamentalism" pressed on the world in the '90s by Summers, Geithner and their mentor, former Treasury secretary Robert Rubin—advice that has now contributed to the worst financial crisis since the Great Depression.

It's not just that Stiglitz's Nobel-winning work, building on John Maynard Keynes's insights, uncovered profound fallacies in the Reagan-era idea that markets, especially in finance, can always correct themselves (good call, Nobel committee). In his writings and speeches since serving as chairman of Bill Clinton's Council of Economic Advisors and then chief economist of the World Bank, Stiglitz has been the leading voice opposed to the mindless liberalization of capital flows that brought us to where we are today.

In a spate of books, essays and speeches dating from the early '90s, Stiglitz denounced Rubin's support for repeal of the Glass-Steagall Act, which separated commercial from investment banking for precisely the reasons we are now witnessing on Wall Street: new "full-service" banks would seek to hype companies that their stock-market side underwrote and issue loans to them even if they were not credit-worthy.

"The ideas behind Glass-Steagall went back even further [than the 1929 crash] to Teddy Roosevelt and his efforts to break up the big trusts," he wrote presciently in "The Roaring Nineties" (2003). "When enterprises become too big, and interconnections too tight, there is a risk that the quality of economic decisions deteriorates, and the 'too big to fail' problem rears its ugly head."

Unfortunately, Stiglitz wrote, his worries "were quickly shunted aside"' by the Clinton Treasury team. Earlier, in his book "Globalization and its Discontents" (2002), Stiglitz became the most prominent voice in Washington to say plainly that free-market absolutism, which began with the Reagan revolution and continued under Clinton (who upon being elected declared the era of "big government" was over), was ill-founded theoretically and disastrous practically. "In 1997 the IMF decided to change its charter to push capital market liberalization," he wrote. "And I said, where is the evidence this is going to be good for developing countries? Why haven't you produced some research showing it was going to be good? They said: we don't need research; we know it's true. They didn't say it in precisely those words, but clearly they took it as religion."

As far back as 1990, Stiglitz argued in a paper (it can be found on The Economist's Voice Web site at www.bppress.com) against securitizing mortgages and selling them because "when banks retained the mortgages which they issued, they had greater incentives to screen loan applicants." He asked, again with startling prescience: "Has securitization been a result of more efficient transactions technologies, or an unfounded reduction in concern about the importance of screening loan applicants?"

None other than Milton Friedman, the founding father of the free-market era, told me in an interview before he died that Stiglitz also had been more correct than everyone else about how to transform Russia into a market economy when he argued that institution-building and creating regulatory authorities were an important preliminary step. "In the immediate aftermath of the fall of the Soviet Union, I kept being asked what the Russians should do," Friedman told me in 2002. "I said, 'Privatize, privatize, privatize. I was wrong. Joe was right. What we want is privatization, and the rule of law."

The son of a schoolteacher mother and insurance-salesman father, Stiglitz grew up in one of the grittiest industrial cities in American—Gary, Indiana—and was shaped by the social inequality and labor strikes he observed there. (Yeah, he's a liberal; am I wrong in suggesting, in the wake of this disaster, that we can use the L word as something other than an epithet again?) In 2001, Stiglitz shared the Nobel Prize for Economics for pioneering work in which he argued that financial markets especially are prone to act on imperfect information, leading to unnecessary panics, manias and bubbles and necessitating government intervention.

Like Keynes himself, who fought successfully to block "hot money" at the postwar Bretton Woods conference in 1944, Stiglitz understood the problem of international capital flows like few others of his era. As his longtime collaborator Bruce Greenwald—another Columbia professor who, by the way, is a conservative Republican—puts it: "You need radical global reform" to correct chronic imbalances in capital flows, all of which Stiglitz has laid out in his book, "Making Globalization Work." "There's no chance these guys are going to do what's necessary," with the possible exception of Summers, says Greenwald.

And without those additional steps, he warns, the fiscal stimulus that the Obama administration is now putting its hopes on won't avert the devastating recession to come. "Unemployment is going to go to 6½ percent, then to ten percent by the end of 2010. When it goes to 14 percent by 2012, Obama and the Democrats are going to be toast." (Tommy Vietor, a spokesman for the Obama transition team, declined to comment.) 

Keynes is dead, but we still have Joe Stiglitz. And so the question is: what is he doing in New York? Sure, I know the rap on Stiglitz: while he's personally a gentleman, he's too often "off the reservation," won't stay on the message, and doesn't play well with others—especially Summers. (Summers is said to have pressured former World Bank president Jim Wolfensohn to fire Stiglitz in the '90s; he left under pressure in late 1999.)

Unquestionably, Stiglitz has occasionally gone overboard in his criticisms, such as when he suggested, outrageously, that the eminent economist Stanley Fischer—a former senior IMF official who taught both Summers and Fed Chairman Ben Bernanke at MIT—had pushed for capital-markets liberalization in the '90s so he could secure a fat job at Citigroup afterwards. But Obama has made a point of declaring that he wants dissonant voices in his administration. So why not Joe Stiglitz?

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