I enjoyed this interview and hope you will, too:
BARRON’S The Dangers of Lessons Unheeded
By LESLIE P. NORTON
SATURDAY, MARCH 19, 2011
A Nobel Prize-winning economist says the West hasn’t learned much from Japan’s long slump or the struggles of Hoovernomics.
The exceptionally lucid Columbia University professor is one of the world’s most widely quoted economists, especially since he won the Nobel Prize for Economics in 2001. It’s easy to see why: A prolific author, he helped wake Americans to the consequences of economic integration with the global economy (Globalization and its Discontents, 2002), published a gritty analysis showing the surprisingly high costs of the Iraq War (The Three Trillion Dollar War, 2008), and most recently, explored the forces behind the financial crisis (Freefall: America, Free Markets, and the Sinking of the World Economy, 2010). Often controversial, but always worth listening to, Stiglitz shared his views about the global economy while in Japan, where he attended meetings after the earthquake. Then, he flew to China.
Barron’s : How bad is it in Japan?
Stiglitz: There are high levels of anxiety. They don’t have a full account of the damage. There’s an orderliness you don’t see in many countries in times of crises. It’s very disciplined, and very orderly. But the world’s third-largest economy, which used to be the second-largest, is going to be obviously traumatized for an extended period. They’ve loosened policy to try to prevent the market from going down more than it has.
In the short term, there will be a negative jolt. In the intermediate term, when they figure out the electricity situation and come to terms with it, there will be increasing GDP as they reconstruct, address questions like whether they need to build bigger seawalls, diversify their electricity system, and renew their commitment to energy efficiency which will require more investment. But their imports of consumer goods will go down and that’s a bad thing for the global economy. They will be much poorer, in a way I describe in my book Mismeasuring Our Lives: Why GDP Doesn’t Add Up. It will look like Japan is doing well, but [there will be] destruction of wealth.
The sad thing is that they’ve never fully recovered from the bubble of 1989 bursting. In that sense it should remind the U.S. of what happens if you allow a bubble to get outsized. It’s water under the bridge, but Bernanke and Greenspan have to bear some responsibility for that ideology that bubbles don’t really exist, and they clearly do. When we went into this financial crisis, the administration said, “We won’t make the mistake of Japan and delay restructuring.” That’s exactly what we did. It’s mind-boggling that we haven’t learned any of the lessons of Japan.
Before we talk about all that, what are the most surprising developments since you won your Nobel Prize?
Surprising to whom? The bubble episode surprised so much of the world—Greenspan and Bernanke believed that markets knew how to handle risk, self-regulation was adequate and the banks had incentives to manage risk and so forth and so on. We saw that it isn’t true—in a very dramatic way. That wasn’t surprising to me because my Nobel Prize was about the economics of information and this notion of agency theory, that the people who are making decisions do not necessarily reflect the interests of those who they are supposed to be serving.
The kind of incentive schemes that were being employed by firms, banks and financial institutions weren’t consistent with any model of rational behavior other than exploitation. If you believe incentives matter, something untoward was going to happen. At the level of markets, securitization had some fundamental flaws, because you didn’t have the incentives to monitor or manage them and created a moral hazard. To our leaders and erstwhile gurus, it came as a very big surprise. You have a market economy where incentives do matter, but in which they aren’t always aligned.
Have you had to adjust your thinking in any way?
I have been quite honestly surprised at how well Asia has been doing. These are export-driven economies that have gotten a very big shock to their export markets, and they’ve managed to survive, prosper, and begin to develop their internal markets.
The second surprise is that I thought there would be a greater public understanding of the failures that occurred. Unfettered markets really don’t work, and we need to do something about too-big-to-fail banks etc. Obama is a little bit of a surprise. One would have thought this was an opportunity to redefine the market economy. In France and Germany, there has been a lot of discussion about the lessons. The Financial Crisis Inquiry Commission here clearly said this was a man-made crisis. But the political response is to come to the aid of big banks and leave their power basically unchecked. The consequence for the U.S. is very unhealthy. A lot of people, including the Tea Party movement, have come to the view that our government has been captured. I also assumed there would be checks and balances that would prevent some of the worst excesses, for example the repeal of Glass-Steagall. But the conflicts of interest have been much worse, and the problems of increased concentration of the banking system have just been phenomenal.
On the positive side, one new, vibrant area that’s taken off is the study of how interconnectivity can lead to instability. We economists hadn’t focused on financial interactions and how that can lead to financial instability. Believe it or not, most models used by central banks only looked at savings, ignoring credit institutions and securities markets. That reflected a mainstream view that institutions don’t matter. This was cognitive dissonance of a high order.
You’re famous for criticizing the IMF during the 1998 Asian financial crisis. But now Asia has the planet’s strongest economies.
The overwhelming evidence is that the austerity in East Asia was a disaster. It made their economies weaker; it basically lost them two or three years. When they pushed aside the IMF and followed policies markedly different from those advocated by the Washington consensus, they grew robustly. The positive thing that came out of the East Asia crisis was a determination never to become reliant on the IMF again. It provided an impetus for them to follow courses that were very non-Western: They didn’t do the rapid financial capital-market liberalization that the IMF had advocated. Had they done so, they would have the same kind of instability that we in the U.S. and Europe have had.
Secondly, they put aside a lot of money, increased their reserves and that meant that they had far more ability to withstand the crisis. But now, it presents a problem for global recovery. Money that isn’t spent lowers global aggregate demand. And the world faces a lack of aggregate demand today.
Is the growth in Asia sustainable?
Yes. Perhaps too much emphasis was placed in the past on trade, which was a key ingredient for priming the engine, getting them going. But per-capita income in China and India is still a fraction of that in advanced industrial countries, which means that they have scope for increasing per-capita human capital and knowledge. As they close that gap, their incomes will grow at very rapid rates. While there are limits on the normal pace of resource accumulation, there are no theoretical limits on how fast you can close the knowledge gap. Obviously, trade makes things easier. A weak Europe and America will force them to transform their economies faster, and that transformation is costly.
Because it’s Lent, it seems like a good time to talk about austerity. How weak will Europe be? Or America, which has had a very different policy response?
Europe’s unemployment will remain higher than the U.S. There will be a lot of volatility. We have already seen a double-dip in the U.K., and we’ve seen Greece go into negative territory, along with the other periphery countries, but I don’t see it for Europe as a whole. The crisis and the resource shock is impeding Spain’s ability to restructure, in spite of all the good intentions of the government. It’s been a single bad dip for them. I am surprised that so many European leaders and some Americans, having seen the disaster of Hoover economics, are still going ahead with austerity. The evidence is overwhelming that it will lead to an economic slowdown.
The problems in Ireland, Greece and Portugal haven’t gone away, and the markets in their irrational way will episodically focus on them. When it does, the euro will go down, and that will be good for Germany, which is well structured for exports, and might trickle down to some other European countries. It is an unintended, but beneficial, consequence of the market irrationality.
This is where Europe and the U.S. clearly interact. The president made it clear that he hoped for us to have an export-led recovery. Our biggest market is Europe. Even if China starts consuming more, it will consume manufactured goods, education and health care made in China. And if China boosts its currency’s value, we are going to be buying textiles from Sri Lanka and Bangladesh. Our real concern is Europe. A weak euro will make it more difficult for us to export and to recover.
What about oil?
Although as a share of U.S. gross domestic product, oil imports have gone down, it’s still a huge number and if prices go up by 20% or 30%, that increases our import bill and that money isn’t available to spend at home. One of the points I made in my book with Linda Bilmes, The Three Trillion Dollar War, was that the high oil prices caused by the war had a very depressing effect on the economy. At that point, we could counter it with low interest rates, which of course contributed to the bubble. So, ironically, you could blame the bubble in part on high oil prices. The economy ran into problems when oil prices continued to rise and set in motion inflationary pressures, and the Federal Reserve felt that its mandate to keep inflation down meant it couldn’t offset them. That’s when the bubble burst. Now we’re in this unusual situation, with no room to maneuver on rates, but with some pressure instead to raise them like in 2008. We are lucky compared to other countries because energy prices and food prices are a small fraction of our consumer price index. Other countries, though, if they still believe in the doctrines of inflation targeting, may raise interest rates. That will slow the global recovery.
Another way of thinking about this is that it’s a redistribution of income from the rest of the world to the oil-producing countries. You are taking money away from people who spend it and giving it to people who rationally don’t spend it because it’s temporary. So this is going to be bad for global aggregate demand. The higher oil goes, the more central banks will be led into raising interest rates, slowing their economies and leading to more money being transferred from those who spend to those who don’t.
The other factor is that many Americans are facing financial constraints, trying to deleverage, rebuild balance sheets. An increase in oil prices is very similar to an increase in taxes from their point of view. Their income is going down and, because labor markets are weak, wages aren’t going up very much. The impact of an increase in taxes is more significant when households face financial constraints.
One other aspect that I don’t know how to assess is the interaction between house prices and energy prices. Houses in suburbs and exurbs are dependent on the price of oil. In the short run, it might mean that house prices in exurbia and suburbia, which in many areas are already weak, may go down even more.
Meanwhile, QE2 is running out and Bill Gross just sold his Treasury bonds.
These things will make very little difference. Real rates have increased since [quantitative easing] began. There are two categories of firms. One is big multinationals that are awash with cash and won’t be affected by a slight change of interest rates. The other is the small and medium-size enterprise, where credit flow is choked. That hasn’t been fixed. If anything, QE2 has contributed to the creation of bubbles elsewhere reverberating back to higher commodity prices. [Chinese Prime Minister] Wen Jiabao last week blamed countries engaged in quantitative easing for this.
It’s very difficult to get a clear picture of the U.S. economy at this point. The one-year payroll-tax cut is putting more money in people’s pockets at the same time that the increase in oil prices is taking money out. Both are of uncertain duration. The Republican strategy of encouraging government at the state, local and federal level to weaken collective bargaining means all Americans should be worried about their future and sends a strong message: “Don’t spend.” And to the extent that people pay attention to deficit-commission reports, it’s another big damper that says, “Don’t buy a house now, because you may not even be able to get a mortgage deduction.”
Is Obama in deep trouble?
A lot depends on whether he succeeds in framing the issue. In the summer of 2012, the unemployment rate almost surely will be north of 8% or 7.5%. No one thinks it will be better than that. In an objective sense, the situation is dismal. If he can frame it to say he inherited a big mess, pulled us back from the brink and made steady improvement, people will say he’s done a reasonable job. But that narrative is getting old, and it’s hard to sell.
The narrative on the right doesn’t make a lot of sense: It’s the inherited weakness of the economy that caused the deficit, not the other way around. The solution to the deficit problem is putting America back to work and austerity measures go exactly in the opposite direction. The mainstream of the Republican Party is corporate welfarism. The Tea Party has an intellectual constituency to get government out, even though it was too little government that failed to stop the banks’ behavior and caused the crisis. The incoherent alliance between corporate welfarism and intellectual libertarianism may prove effective, but that depends on the ability of the Republican Party to come together with a plausible candidate.