Transcript Keys to Future Stability and Growth: Lessons from the Global

Keys to Future Stability and
Growth:
LESSONS FROM THE GLOBAL ECONOMIC
CRISIS
Joseph E. Stiglitz
Shanghai
May 14, 2009
Failures of America’s Financial System
Didn’t manage risk—created risk
 Misallocated capital

 Too much into housing, too little to real
investment, innovative sector, improving
environment

High transaction costs
 Resisted creation of an efficient electronic
transfer system

Predatory lending practices
Failures of America’s Financial System

Innovations directed at regulatory,
accounting, and tax arbitrage
 Little innovation at meeting society’s real
needs
○ For example, managing the risk of most family’s
most important asset—their home
Failed at both micro and macro level
 Major social problems—devastation of the
poor in America
 Global macro-problem

“Model” didn’t work

Self-regulation didn’t work
 Perverse incentives
 Self-regulation can’t work—externalities

Model of risk diversification (securitization)
didn’t work
 Increased information asymmetries
 Systems of market checks and balances failed
(credit rating agencies)
 Regulatory checks and balances failed
○ Ideology
○ Capture
The current crisis and where
the system failed

Incentives
 Market participants had incentives to engage in
excessive risk taking/short sighted behavior
 Conflicts of interest

Transparency
 Market participants had incentives and
instruments for non-transparency
 But failure was more than that of transparency:
complexity

Competition
 Too big to fail institutions had incentives to engage
in excessive risk taking
 Competition didn’t work—race to the bottom
What are the key factors in the design of a
new regulatory structure and system ?
Asymmetries and imperfections of
information
 Moral hazard
 Human fallibility/ “behavioral” economics
 Externalities

st
21
Creating a
century
financial system

As America went about saving its
financial system, it should have asked,
what kind of a financial system did it
want for the future
 Couldn’t, shouldn’t go back to the failed
system of the past
 At the very least, downsizing scale
 Question—which parts to downsize?
○ Some worked well—they should be expanded
st
21
Creating a
century
financial system
China needs to ask same question
today as it creates a new regulatory
structure
 An “ecology” of financial institutions
serving different needs

Key functions of financial
regulation
Safety and soundness of individual
institutions (micro-prudential regulation)
 Macro-stability (macro-prudential
regulation)

 Manner in which micro-prudential regulation
had been conducted undermined macrostability
Competition
 Consumer/investor Protection
 Access

Key features of new regulatory system

Regulation has to be comprehensive
 Globally, domestically
 Products, Institutions
Transparency
 But transparency is not enough--complexity
 Restrictions on incentives—including
incentives that encouraged lack of
transparency, excessive risk taking, short
sighted behavior

 Restrictions
on size
 Restrictions on risk taking
 Financial product safety commission
Key principles to be safeguarded/
put in place

Mark-to-market—best information available
 Care in regulatory use of information
 Care in design of mark to market system
Restrict or inhibit the use of over-the- counter
derivatives
 Restrictions on leverage, countercyclical
provisioning/capital adequacy
 Have the voice of those whose interests are
likely to be hurt be well represented in the
regulatory structure


A good regulatory system can contribute to
a more dynamic, innovative economy, a
more efficient economy, a more stable
economy, and a more “harmonious”
society

Can’t return to the world as it was before
the crisis
But more than financial
regulation is required

Corporate governance
 Failures led to flawed incentive structures
○ Which didn’t serve shareholders or customers
well

Anti-trust policy
 Not just concerned with market power
 But risks imposed on society
 And political power
○ Original concern in the creation of anti-trust
policies
And more than regulation is
required

Government may have to take a more
active role in finance
 Creating an efficient electronic transfer
mechanism
 Lending to the poor—temptation for
predatory lending too great
 Providing good risk products (Danish
mortgages, inflation indexed bonds)
CHANGING GLOBAL
LANDSCAPE
China likely to remain major global
creditor/major source of savings in
global economy
 Makes sense for intermediation services
to be provided in country doing savings
 Especially natural to raises questions
about intermediation through US

 Financial system there failed
 Instability of dollar may be increasing
Rethinking our Financial System






America’s financial system failed—at great
cost to America and the world
It is important for America and all other
countries to learn the right lessons
There had been a race to the bottom
We should now have a race to the top
What is at stake is not just a matter of
economic stability and growth
But social stability and a harmonious society