Freefall- a manifesto for economic change

As markets tumble in Europe, America and across the globe, the world is waking up to reality: the recession is back. Indeed it never really went away. How much of this can really be a surprise? We have more or less the same economic system today as that which brought the economy to its knees just three years ago. In 2008 policy makers could at least plead naivety. Who could have seen the sudden collapse of the world’s largest banks? And who could have known just how interconnect companies and countries had become?
But these rhetorical questions do in fact have answers: Joseph Stiglitz, professor of economics and Nobel laureate, was our Cassandra.  He was preaching long before the housing bubble and credit default swaps of the inherent dangers posed by lax legislation and misaligned incentives. His 2010 book Freefall, recently updated, is his victory lap. But more than “I told you so”, Stiglitz offers a way out of the mire. Politicians would do well to head his advice.
Market Failure

Stiglitz lays the blame for the crisis squarely, triangularly and circularly at the feet of free markets and their ideologue proponents. I’ve blogged before about my own flirtatious relationship with free markets and identified some of their key failings. One failing I didn’t mention was externalities, which was a failing central to the near collapse of the financial system and one which Stiglitz emphasises.  Externalities are by-products of business where there is no market mechanism to account for them- sometimes positive, sometimes negative. If I own a bee farm and an orchard sets up next door, the orchard benefits significantly from my bees’ polination without affecting me. But should the orchard owners not pay for this privilege? This is an externality– the market provides no way of paying me. A negative externality would be global warming- harm is caused by business but not in a way penalised by the markets. 
Stiglitz argues that banks, with their light touch regulations, posed huge negative externalities on the economy as a whole in a number of ways: the misunderstanding of risk, performance related pay and implicit government subsidy.
Risky business

Before making a loan, banks need to understand the risk associated with the borrower defaulting and adjust the interest rate accordingly. But to further decrease risk, banks started to package loans together with assumption that the more loans one had, the more the risk was spread out. This was fine, provided defaults weren’t correlated. But when house prices started to fall across the country, defaults became very correlated indeed. Because many of these loans had been packaged together in highly complex ways, banks suddenly realised that they couldn’t really tell which loans were safe and which weren’t. They also couldn’t trust the safety of other banks and so stopped lending to each other, resulting in the credit crunch. Stiglitz verdict is clear- commercial banks shouldn’t be allowed to create products they don’t fully understand. As US Treasury Secretary Henry Paulson quipped, “the only useful financial innovation in recent decades has been the cash machine”.
Performance related pay and other oxymorons

Performance related pay was abandoned by most professions when it became clear that it rewarded quantity, not quality and encouraged short term results. These are precisely the problems plaguing modern banking. Bonuses are paid for gains but not removed for losses, promoting excessive risk taking as bankers just couldn’t lose. Mortgage vendors were rewarded according to the number of mortgages issued, not their quality, leading to the phenomenon of “liar loans” for which borrowers required no proof of income. Even after the Crunch, the flow of bonuses continued, making a mockery of the claim that they were performance based.
Bankers on benefits

But perhaps the strongest externality was the implicit guarantee that the government would always save the biggest banks to protect the rest of the economy. This safety net enabled banks to take much greater risk at much lower interest rates- a subsidy of billions of dollars, greatly distorting the market. When the bailouts were received, very little was loaned on to small and medium sized business, the risks of speculation were still too tempting.
What’s to be done?

Stiglitz is no communist and recognises the importance of markets- the key is regulation. As the world sits on the brink of what may well be a double dip recession, here are his suggestions for policy changes to make a difference-
  1.    Separate commercial banks from investment banks- banks shouldn’t be taking huge risks with ordinary households’ money.
  2.      Require banks to keep some of the mortgages they sell on their books to ensure they have a vested interest on providing loans to those how can afford them.
  3.     Give share holders greater say over executive pay and stop payments in stock options- they encourage short-term thinking.
  4.     Require bailout funds to go to small and medium sized business. Much of it is their money, after all.

This is Stiglitz’s manifesto for change. Free markets have failed but markets can still work within sensible rules.  Failure to change in 2008 brought around the current difficulties. The world cannot afford to make the same mistake twice.

Trying to be Less Evil

I have a confession to make. Over the last year or so, I’ve been really quite evil. I really never meant to be, but there it is. Evil as a doorknob. Like many of my ilk, I can pin point the exact day the evil started, it was in November 2009 and I was in the Felix office, chatting to the business editor (you know who you are!). The chat went something like this,
Moi: The government should really pay for education/ health/ hash brownies for the poor.
Satan: Well, if it’s such a good thing, why don’t richer people just pay for it for them anyway? Can’t people just be charitable, or are you saying the government is more moral than everyone else?

And there the bastard had me. Wouldn’t it be a whole lot better if people just came together themselves and sorted out each other’s difficulties? What was it that made government intervention so much better than private action? This got around a WHOLE load of issues too. Want your child to learn evolution? Set up a school that does it. Want poor kids to learn about evolution? Set up a school for them too. Is it really that different from the government doing it? In fact, it should be better- being controlled from near, not Whitehall, means better efficiency and accountability. On top of that, surely the freedom to teach as you wish has a moral value to it? It’s not like current state schools are anything to write home about. Assuming you can write, that is.
I started to see the benefits of privatisation everywhere. I didn’t believe that cuddly services such as health and education should be run purely in pursuit of profit, rather that the freedom should be given to professionals, patients and parents to make their own decisions about services and this freedom comes from privatisation. Every time someone complained that the government should do more for such and such I’d think, “Why don’t you just go ahead and do it, or convince professionals to?” At every stage this was my outlook. How on earth could the government do something better than its citizens, I thought. Yes, most of us don’t have the expertise to set up a school, but neither do most politicians. They hire professionals with our money, why not cut out the middle man and hire them ourselves?
But I wasn’t an evil voice in the wilderness, I had my Gospel and I really did read it religiously; The Economist magazine. You really have to read the thing to understand its allure, but basically it kept me in market- loving, unions- hating rapture for hours on end every week. And when my sister got me a Kindle subscription for Christmas? In the Holy Name of Friedman, I just didn’t stand a chance.
It all reached its zenith when, one fateful May morning, I put an x beside the name of Sir Malcolm Rifkind, Conservative MP for Kensington, my constituency. Yes, that’s right. I’m Rory the Tory. Rory the Milk Snatcher. The Sheriff of Ror-ingham.
But things have since changed. Let me be clear, I really didn’t mean to be evil. I honestly believed the in freedom, efficiency and accountability that letting the market into public goods would bring. I now realise I was mistaken. The purpose of this blog is to explain just why I was mistaken: why markets really aren’t as wonderful as free marketers such as my younger self might hope. Perhaps in the process some other poor devils might realise the errors of their market orientated ways, too.
Market Failure

Even in theory, markets can’t always work properly. A year ago, I’d have said that if there were a more efficient way of doing something, the market will always find it and adopt it, as otherwise businesses wouldn’t survive. Unfortunately, this isn’t the case and market failures can appear in two fundamental ways.
The problem of Lemons. Firstly, I have no problem with fruit and neither do markets. We’re talking about Lemons with a capital ‘L’; crap cars. It’s a well known fact that the very second you drive a new car out of the car shop, it drops fabulously in price in a way that doesn’t make perfect sense. It’s true that everyone likes the idea of being the first owner of a car, but not so much that they would insist on paying many thousands of pounds less just because someone had ‘her’ for a week. Instead, there’s a classic market failure operating.
Imagine you see an ad for a car. It’s almost new and so going for a price not too far off what it would have been hot off the shelves (that’s how a car shop works, right? Shelves and massive industrial trolleys?). It seems like a good deal, but something’s bugging you. If the car’s really so good, why is the guy trying to sell it? Sure you can give it a test drive and check out the MOT, but all that already takes up time and time is money, already making the car more expensive. And even if the MOT etc checks out you’ll still be left wondering why this car’s on sale- unless it’s faulty? Because you don’t know everything there is to know about the car, there’ll always be that doubt. Coupled with the extra money and time it takes to check the car out, this means that inevitably you’re going to offer a lower price than the seller should really get for the car, to compensate for the uncertainty.
But now look at it from the car owner’s perspective; he realises that if he tries to sell the car, the above reasons will mean he gets a poor price. Which means that unless there is an emergency (a new baby, unemployment) he has little incentive to sell a perfectly good car. Unless, of course, it’s faulty. Then he still has every incentive to get rid of the thing.
And now we can see that both buyer and seller will create a spiral; the buyer is scared of Lemons so he offers a low price, the seller doesn’t like the low price so he only sells if he has a Lemon which means even more used cars are Lemons which means the buyer will offer even less to compensate for  the risk and so on. This isn’t so bad when it comes to cars and manufactures now offer guarantees on used cars to alleviate this but it’s still an issue. The big problem is the exact same market failure exists in healthcare- just as Lemons are more likely to be put up for sale, sick people are more likely to take out health insurance. People getting lower prices than they would like for their cars is ok, but sick people finding themselves priced out of insurance really isn’t. There is a clear case for government intervention here. This leads us to the next market failure;
The prisoners’ dilemma. Thisun’s a nice economics parable. There are two recently arrested prisoners being interrogated separately by police. Whatever evidence the police have, it’s not enough for a conviction. The prisoners are each given a choice; either own up to what you and your friend did, in which case you get 2 years in prison and the other guy 10, or you can keep quiet but if the other guy ‘fesses up things are reversed, he gets 2 years you get ten. If you both confess, you get 5 years each. A confusing state of affairs, but it’s clear that the best result for both is to keep quiet. The problem is, since neither of them can be sure the other won’t say anything, the most rational move for each is to confess, rather than run the risk of being the only silent one. All things being equal, keeping quiet gets you an average of 5 years locked, speaking out gets you just 3.5. Two rational prisoners will always tell on each other, leaving both unnecessarily in prison.
There are many real world examples of this, an obvious one being hygiene. Sandwich shops, for example, would have no incentive to spend a small sum on making clean sandwiches if it means making them slightly less competitive than rivals, despite the fact that sandwich shops making people ill is bad for the industry as a whole. Clearly businesses need educated workers and yet it makes no sense for any individual business to invest in schools if those guys are just going to work for someone else. Again, there’s a clear case for government intervention here.
Halfway to Damascus

I was gradually convinced that markets, however rational, could never fully create the optimal outcome for everyone and, sadly, it’s the poorest who would lose out the most. I’m no commie, mind, but these are sensible reasons for a well regulated market system with social welfare and public goods. I haven’t changed altogether. In an election tomorrow, I would still vote Tory (they’re hardly full on free marketers these days) and I don’t necessarily support every last penny spent in the name of welfare. So I’m a long way from skipping down a small country lane with pretty petals in my hair nursing an injured baby rabbit, but the evil has rescinded, somewhat.
A blog for another time, perhaps, but how come nothing happened about the free market ideology that lead to the current recession…? Thoughts on a postcard please.