Book of the week: Freefall: Free Markets and the Sinking of the Global Economy

Arrogance and avarice caused the crash, and they're still going strong, learns Michelle Baddeley

February 25, 2010

It is easy to forget that the financial crisis has a human dimension - a dimension that has been lost in financial jargon: sub-prime mortgages, derivatives, securitisation, collateralised debt obligations and credit default swaps.

The danger with the technical post-mortems is that many will have no sense of the real implications. In ordinary language, financial engineers spotted opportunities to make profits from predatory lending to the poor and/or financially illiterate - people who didn't always understand the implications of their excessive borrowing. Some of the products included payday loans secured against the borrower's next pay packet but accruing exorbitant interest rates.

More significantly, mortgages were bundled into packages that were then sliced up into "new" assets to be sold and resold (far and wide) until the connection between borrower and lender was all but lost. The justification was a few sanguine assumptions. Markets work. Correlations between risks of loss on one asset and losses on another are small. House prices will rise, and rise, and rise. These assumptions, as some economists had predicted, proved very fallible - and when the financial system fell, it fell fast. In a globalised and deregulated world, the fallout has been severe, far-reaching and enduring. This is the essence of the compelling, although sometimes esoteric and US-centric, arguments presented by the Nobel prizewinning economist Joseph Stiglitz in Freefall.

Stiglitz is famous and lauded for his analyses of information failure. He touches on these theoretical themes in dissecting the financial crisis and does in part address the insight that "asymmetric information" (occurring when one person knows more than another) stops markets working properly. There are two main types of asymmetric information: "adverse selection", which occurs when individuals and businesses cannot judge the quality of goods and services bought and sold and results in bad-quality products cluttering the market; and "moral hazard", when people have incentives to shirk on their contractual obligations because their irresponsible behaviour cannot be properly monitored and observed. For example, adverse selection meant that financial institutions could sell toxic assets without the buyers realising what they had bought. A current example of moral hazard is that the banks have incentives to engage in risky and/or predatory lending practices because it is difficult and costly for outsiders to monitor their activities. Stiglitz observes that policy responses to the financial crisis have increased the potential for moral hazards in the future: a signal has been sent to the banks that they can get away with risky lending practices because when they make profits they can keep them, but when they make losses they will be bailed out: they are too big to fail.

Like one of his major inspirations, John Maynard Keynes, Stiglitz draws heavily on metaphor in "peeling the onion" that is the complexity of causes underlying financial meltdown - he unpeels the causes of the causes of the causes. Behind the financial jargon, his analysis is a story about the triumph of arrogance and avarice over modesty and prudence. Predatory lending practices encouraged excessive consumption by ordinary households. Financial buoyancy fuelled a party of speculative financial gambling in the rich boys' casino of Wall Street. Not wanting to spoil the party, central bankers (namely, Alan Greenspan, the former chairman of the Federal Reserve) did nothing to rein in these speculative excesses.

Inevitably, the bubble burst; and when it did, the politicians and central bankers bailed out the commercial bankers, draining a lot of taxpayers' money in the process. Gains were privatised and losses were socialised. All these activities were constructed around webs of deceit, secrecy and euphemism: "liar loans" enabled lending to people on a pretence that they were creditworthy; interventions by the Federal Reserve, the US central bank, were shrouded in secrecy and escaped democratic accountability; "toxic" assets became "troubled" assets and then less scary-sounding "legacy" assets. During the good times, bankers were susceptible to fads and fashions; in the bad times, politicians were steered by fear tactics - a fear that capitalism would fall apart.

In identifying the culprits, Stiglitz has a long list of characters including not only banks and commercial bankers, but also central bankers, regulators, the International Monetary Fund, politicians and presidents - Obama as well as Bush. (One leader escaping personal condemnation is Gordon Brown, who receives some rare praise for assuring poorer nations a voice in international negotiations.) The real losers were those who were tricked into excessive borrowing in the first place, such that the burden of the many mistakes was borne not by the unwitting financial engineers of the crisis but by the ordinary people, the poor, the desperate and the poorly educated - all victims of predatory lending practices.

Stiglitz cites the example of Dolores Canales, who was persuaded to refinance her home 13 times in six years on a series of "no-doc" mortgages, which are mortgages given without any documentation to establish that the borrower has the income or assets to repay the loans: "They'd just call and say, 'Hey, do you need money in the bank?' And I was like, 'Yeah, I need money in the bank.'" For some, the end result was deadly: ordinary people facing long-term unemployment, poverty, broken marriages and suicide.

Freefall concludes with a moral and political assessment of the various dimensions of the financial crisis and its causes. The roots of the crisis lay in the exploitation of the poor, with pro-market rhetoric used as the justification. The consequences were real as well as financial - not only in the loss of jobs and output, but also in the loss of faith in democracy. The crisis has revealed dangers and suggested opportunities for reform. Drawing a provocative parallel, Stiglitz observes: "September 15, 2008, the date that Lehman Brothers collapsed, may be to market fundamentalism (the notion that unfettered markets, all by themselves, can ensure economic prosperity and growth) what the fall of the Berlin Wall was to communism."

There may be a silver lining in all this if lessons have been learnt. Banks and financial systems should be re-regulated. If banks are too big to fail, they should be divided up. There should be a return to more traditional lending practices in which the banks know something about their borrowers. More money should be spent on employment generation, social security, training and education, health, international development and innovation, but not financial innovations to help the richest, or labour-saving innovations that limit employment opportunities. Instead, we need innovations with wider benefits for ordinary people and workers; innovations targeted at minimising the negative consequences of environmental damage, for example. A sense of social connectedness between people must be regained.

Ultimately, Stiglitz is pessimistic: in the US at least, vested interests are ensuring that regulations will not get tougher; incentive structures will not be redesigned to encourage bankers to take a longer-term view. It's back to business as usual for the free-marketeers, and in the process the poor are continuing to get poorer and the rich have experienced just a stumble on their path to getting richer.

Freefall sees Stiglitz concluding that while the financial crisis revealed many opportunities to make the world a better, cleaner and more equitable place: "The real danger now is that we will not seize them."


Joseph Stiglitz, who chairs the University of Manchester's Brooks World Poverty Institute and the Committee on Global Thought at Columbia University, is recognised as one of the world's leading economists.

He helped to create a new branch of the field, the "economics of information", elements of which are now standard tools for theorists and policy analysts.

Born in 1943, Stiglitz graduated from Amherst College before taking a doctorate at the Massachusetts Institute of Technology. He has taught at the universities of Yale, Princeton, Stanford and MIT, and is a fellow of All Souls College, Oxford.

He was awarded the Nobel Prize for Economics in 2001 for his analysis of markets with asymmetric information, and was lead author of the 1995 report for the Intergovernmental Panel on Climate Change, which shared the 2007 Nobel Peace Prize with Al Gore.

Freefall: Free Markets and the Sinking of the Global Economy

By Joseph Stiglitz

Allen Lane, 400pp, £25.00

ISBN 97818461496

Published 28 January 2010

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