In response to Professor Joseph's Stiglitz's article, "The Spring of the Zombies" on Project Syndicate
The case for the debt-for-equity swap that Professor Stiglitz has proposed, in this article and in a Charlie Rose show several weeks ago, should be given careful thought. The underlying rationale for the debt-for-equity swap seems to have been born out of Professor Stiglitz's experience in the Council of Economic Advisors for President Clinton in the 90s. The Clinton Presidency is seen today as an era of unprecedented prosperity. Business-friendly policies provided robust growth opportunities which, in turn, ensured large increases in tax receipts, which enabled the Federal government to pay down its massive debts, and project trillions of dollars of budget surplus by the end of the Presidency. On the social front, low unemployment resulted in many benefits, including significant reductions in crime rates. In his book, "The Roaring Nineties", Professor Stiglitz explains that President Clinton had, in fact, run for office on a much broader agenda of societal well-being, during the 1992 Presidential campaign. Unfortunately, after the election, many of those goals had to be curtailed for the immediate need of balancing the federal budget, which had been deep-in-the-red for more than a decade by then. Since balancing the budget was the only issue that bi-partisan consensus could be built on, the liberals had to compromise.
Through the debt-for-equity swap that Professor Stiglitz proposes now, it appears that he wants to provide an exit-strategy for the current Obama administration. An exit from getting its whole agenda for social justice, that President Obama had proposed in his election manifesto, derailed by the necessity to fix the current financial crisis first. Getting the bond-holders who own the banks' debt to accept equity in these banks in-lieu of their debt means that any future losses or profits incurred on the mortgage securities that these banks hold would be shared proportionately between the current debt-holders and the current equity-holders. This debt-for-equity swap relieves the government and the Federal Reserve from the obligation of being permanently ready to bail out the banks whenever they get into serious risk of insolvency and illiquidity. This would allow the Obama administration to focus on its goals of social well-being -- health care, poverty alleviation, crime prevention, education, racial equality, and so on. Another feature of this proposal is that the banks now have to take responsibility for the decisions they made in investing trillions of dollars in mortgage securities. They cannot count any longer in getting bailed out by the Federal Reserve and the US Treasury.
Having already been in office for more than four months now, the Obama administration is quickly running out of time to find a workable solution for the financial crisis. In spite of trillions of dollars spent by the Federal Reserve and the US Treasury to save the banks, it is getting more obvious by the day, that the financial crisis has only been postponed to a later date. President Obama's personal charisma and popularity around the world, and the relief of seeing the incompetent George W. Bush administration leave office have been the major reasons for the recent surge of hopes for an immediate economic recovery. However, an economic recovery that does not address the financial crisis properly would be anaemic at best. So, in the end, Professor Stiglitz's debt-for-equity swap proposal might be the only way out for the Obama administration. Yet, one is filled with much trepidation, when one examines the financial crisis on a subtler level.
Firstly, who are the real bond-holders? These are the average middle-class people, from America and other advanced nations, whose life-time savings have accumulated in pension funds and mutual funds. Among these middle-class folks, the people that have accumulated significant amounts of life-time savings have been those that have worked on professional jobs for more than two decades and are getting close to retirement -- they are in their 40s, 50s, and 60s. These people are going to have to accept significant reductions in their retirement pensions and their individual retirement savings (401(k), etc). Moreover, they are going to have to accept vastly increased levels of uncertainty of income in their senior years.
Secondly, at a deeper level, it is difficult to see how the American economy is going to recover from such a serious blow to its confidence. After ten months of being mollycoddled by the Federal Reserve and the US Treasury, the finance industry would be left to deal with the same dire health of its accounting books that it was faced with in September 2008. In recent years, more than 30% of the profits of US corporations has come from the finance services sector (finance, insurance and real estate). Moreover, as early as 2005, this sector accounted for 20% of the US gross domestic product. Even if such high profit levels could never ever be replicated, unless modern economic theory could provide a convincing explanation for the rationale for such profits in the past, the American economy could not possibly find avenues for growth opportunities in the coming years. What was the American economy doing in the 2000s? Was it simply playing fun-games about paper-profits made from illusory financial transactions, when all the essential goods were being provided at subsidized prices by China?
Put this way, it seems so unbelievable and crude. Yet, famous economists have been stating repeatedly in the past few months that the finance industry needs to go back to the old ways of the 1960s -- when banking was a staid and boring profession. There is a widespread misconception that this financial crisis is a crisis of solvency as well as a crisis of liquidity. If this was the case, the crisis would have been solved by now. To address problems of liquidity, the Federal Reserve is willing to provide unlimited zero-percent financing. To address problems of solvency, the US Treasury is willing to devise endless schemes to take the toxic assets off the banks' balance sheets. However, these efforts have proved insufficient to solve the financial crisis. This is because the financial crisis is concerned about the future expected profits of the financial system. The Wall Street banks are sitting on a gold mine of above 20% annual returns on over a trillion dollars of their own capital. These 20% annual returns are expected to flow in year after year for the next 30 years or so. Unless this situation is analyzed thoroughly and professionally, using tools from modern economic theory, one could not find ways for the American economy to achieve robust growth in the coming years.
Thirdly, by having the government step in and bail out their cronies during the last nine months, the captains of the American finance industry have lost precious time that they could have spent in actually solving the crisis. As I have already explained in my FAQ Q 5, a substantial step towards solving this financial crisis could be taken by establishing a direct channel of communication between the homeowners on Main street and security-owners on Wall street. Instead of this, the Federal Reserve and the government have jumped in and have kept meddling arbitrarily in this process of price discovery. By enabling the Wall street banks to provide incentives and discounts to the home-owners, a robust mechanism for price adjustment could be worked out. This would provide a natural framework for addressing the grievances of both parties involved in the financial transaction (the home-owner and the security-owner).
Fourthly, this financial crisis cannot be solved without obtaining a clear understanding about why the housing bubble of 1998 -- 2007 occurred. In my judgment, such a clear understanding is at least several years into the future. However, I must also say that a recent article by Professors Vernon Smith and Steven Gjerstad ("From Bubble to Depression?", Wall Street Journal, April 6, 2009) provides substantial insights into the causes of the housing bubble. Gaining a complete understanding of the housing bubble from a theoretical perspective could provide substantial benefits in terms of future growth opportunities for America because, although housing seems to be such a mundane activity, millions of investors around the world are fascinated by this aspect of American life.
Fifthly, a debt-for-equity swap at this point would let the finance industry avoid much needed reform. In spite of the financial crisis it has created, the American financial industry has demonstrated expertise in rapidly implementing sophisticated theories of risk management using very powerful computational infrastructure. However, one serious handicap is the centralized nature of decision making in finance. In a recent article in The Atlantic, Professor Richard Florida argued that the financial centers of the world, like New York and London, have developed their expertise in finance over the course of several centuries. A city that functions as a global leader in finance needs to develop a community of experts, including traders, programmers, financiers, economists, lawyers, journalists, newscasters, managers, scientists, mathematicians, insurers, judges, notaries, etc. Moreover, such financial centers always operate implicitly under the political and military protection of its government. As a result, it would not be easy to facilitate the creation of many more global financial centers.
Professor Florida's arguments are indeed quite persuasive. However, the current financial crisis leads one to ask whether excessive reliance on this accumulation of expertise and talent in a single city like New York, ignores the problem that with trillions of dollars accumulating on Wall street and being traded on split-second information, America is unnecessarily taking on huge risks that make its financial system inherently unstable. Wouldn't diversification of financial decision making help to disperse systemic risk? After all, the most credible information about mortgage defaults are spread throughout the local housing markets in the various states of the United States. So if the finance industry had been decentralized, it would have been in a much stronger position to take into account the data from the foreclosures and the falling house prices around the country.
Another important reform needed in the finance industry is to find ways for it to function apolitically and secularly. If the wealth that the finance industry creates would vanish at the first hint of turbulence, even in a favorable political environment like America's, how can one expect to export American financial technology to the world? This is the great challenge for modern finance theory, to figure out which parts of the theory depend on political favors to succeed, and to investigate to what degree are political favors important. These are major challenges for finance theory. The finance industry needs to address these issues in its day-to-day professional practices. Professor Stiglitz is well aware of the undue political influence exerted by the financial system. In fact, he has been writing about it for over a decade now.
The case for the debt-for-equity swap that Professor Stiglitz has proposed, in this article and in a Charlie Rose show several weeks ago, should be given careful thought. The underlying rationale for the debt-for-equity swap seems to have been born out of Professor Stiglitz's experience in the Council of Economic Advisors for President Clinton in the 90s. The Clinton Presidency is seen today as an era of unprecedented prosperity. Business-friendly policies provided robust growth opportunities which, in turn, ensured large increases in tax receipts, which enabled the Federal government to pay down its massive debts, and project trillions of dollars of budget surplus by the end of the Presidency. On the social front, low unemployment resulted in many benefits, including significant reductions in crime rates. In his book, "The Roaring Nineties", Professor Stiglitz explains that President Clinton had, in fact, run for office on a much broader agenda of societal well-being, during the 1992 Presidential campaign. Unfortunately, after the election, many of those goals had to be curtailed for the immediate need of balancing the federal budget, which had been deep-in-the-red for more than a decade by then. Since balancing the budget was the only issue that bi-partisan consensus could be built on, the liberals had to compromise.
Through the debt-for-equity swap that Professor Stiglitz proposes now, it appears that he wants to provide an exit-strategy for the current Obama administration. An exit from getting its whole agenda for social justice, that President Obama had proposed in his election manifesto, derailed by the necessity to fix the current financial crisis first. Getting the bond-holders who own the banks' debt to accept equity in these banks in-lieu of their debt means that any future losses or profits incurred on the mortgage securities that these banks hold would be shared proportionately between the current debt-holders and the current equity-holders. This debt-for-equity swap relieves the government and the Federal Reserve from the obligation of being permanently ready to bail out the banks whenever they get into serious risk of insolvency and illiquidity. This would allow the Obama administration to focus on its goals of social well-being -- health care, poverty alleviation, crime prevention, education, racial equality, and so on. Another feature of this proposal is that the banks now have to take responsibility for the decisions they made in investing trillions of dollars in mortgage securities. They cannot count any longer in getting bailed out by the Federal Reserve and the US Treasury.
Having already been in office for more than four months now, the Obama administration is quickly running out of time to find a workable solution for the financial crisis. In spite of trillions of dollars spent by the Federal Reserve and the US Treasury to save the banks, it is getting more obvious by the day, that the financial crisis has only been postponed to a later date. President Obama's personal charisma and popularity around the world, and the relief of seeing the incompetent George W. Bush administration leave office have been the major reasons for the recent surge of hopes for an immediate economic recovery. However, an economic recovery that does not address the financial crisis properly would be anaemic at best. So, in the end, Professor Stiglitz's debt-for-equity swap proposal might be the only way out for the Obama administration. Yet, one is filled with much trepidation, when one examines the financial crisis on a subtler level.
Firstly, who are the real bond-holders? These are the average middle-class people, from America and other advanced nations, whose life-time savings have accumulated in pension funds and mutual funds. Among these middle-class folks, the people that have accumulated significant amounts of life-time savings have been those that have worked on professional jobs for more than two decades and are getting close to retirement -- they are in their 40s, 50s, and 60s. These people are going to have to accept significant reductions in their retirement pensions and their individual retirement savings (401(k), etc). Moreover, they are going to have to accept vastly increased levels of uncertainty of income in their senior years.
Secondly, at a deeper level, it is difficult to see how the American economy is going to recover from such a serious blow to its confidence. After ten months of being mollycoddled by the Federal Reserve and the US Treasury, the finance industry would be left to deal with the same dire health of its accounting books that it was faced with in September 2008. In recent years, more than 30% of the profits of US corporations has come from the finance services sector (finance, insurance and real estate). Moreover, as early as 2005, this sector accounted for 20% of the US gross domestic product. Even if such high profit levels could never ever be replicated, unless modern economic theory could provide a convincing explanation for the rationale for such profits in the past, the American economy could not possibly find avenues for growth opportunities in the coming years. What was the American economy doing in the 2000s? Was it simply playing fun-games about paper-profits made from illusory financial transactions, when all the essential goods were being provided at subsidized prices by China?
Put this way, it seems so unbelievable and crude. Yet, famous economists have been stating repeatedly in the past few months that the finance industry needs to go back to the old ways of the 1960s -- when banking was a staid and boring profession. There is a widespread misconception that this financial crisis is a crisis of solvency as well as a crisis of liquidity. If this was the case, the crisis would have been solved by now. To address problems of liquidity, the Federal Reserve is willing to provide unlimited zero-percent financing. To address problems of solvency, the US Treasury is willing to devise endless schemes to take the toxic assets off the banks' balance sheets. However, these efforts have proved insufficient to solve the financial crisis. This is because the financial crisis is concerned about the future expected profits of the financial system. The Wall Street banks are sitting on a gold mine of above 20% annual returns on over a trillion dollars of their own capital. These 20% annual returns are expected to flow in year after year for the next 30 years or so. Unless this situation is analyzed thoroughly and professionally, using tools from modern economic theory, one could not find ways for the American economy to achieve robust growth in the coming years.
Thirdly, by having the government step in and bail out their cronies during the last nine months, the captains of the American finance industry have lost precious time that they could have spent in actually solving the crisis. As I have already explained in my FAQ Q 5, a substantial step towards solving this financial crisis could be taken by establishing a direct channel of communication between the homeowners on Main street and security-owners on Wall street. Instead of this, the Federal Reserve and the government have jumped in and have kept meddling arbitrarily in this process of price discovery. By enabling the Wall street banks to provide incentives and discounts to the home-owners, a robust mechanism for price adjustment could be worked out. This would provide a natural framework for addressing the grievances of both parties involved in the financial transaction (the home-owner and the security-owner).
Fourthly, this financial crisis cannot be solved without obtaining a clear understanding about why the housing bubble of 1998 -- 2007 occurred. In my judgment, such a clear understanding is at least several years into the future. However, I must also say that a recent article by Professors Vernon Smith and Steven Gjerstad ("From Bubble to Depression?", Wall Street Journal, April 6, 2009) provides substantial insights into the causes of the housing bubble. Gaining a complete understanding of the housing bubble from a theoretical perspective could provide substantial benefits in terms of future growth opportunities for America because, although housing seems to be such a mundane activity, millions of investors around the world are fascinated by this aspect of American life.
Fifthly, a debt-for-equity swap at this point would let the finance industry avoid much needed reform. In spite of the financial crisis it has created, the American financial industry has demonstrated expertise in rapidly implementing sophisticated theories of risk management using very powerful computational infrastructure. However, one serious handicap is the centralized nature of decision making in finance. In a recent article in The Atlantic, Professor Richard Florida argued that the financial centers of the world, like New York and London, have developed their expertise in finance over the course of several centuries. A city that functions as a global leader in finance needs to develop a community of experts, including traders, programmers, financiers, economists, lawyers, journalists, newscasters, managers, scientists, mathematicians, insurers, judges, notaries, etc. Moreover, such financial centers always operate implicitly under the political and military protection of its government. As a result, it would not be easy to facilitate the creation of many more global financial centers.
Professor Florida's arguments are indeed quite persuasive. However, the current financial crisis leads one to ask whether excessive reliance on this accumulation of expertise and talent in a single city like New York, ignores the problem that with trillions of dollars accumulating on Wall street and being traded on split-second information, America is unnecessarily taking on huge risks that make its financial system inherently unstable. Wouldn't diversification of financial decision making help to disperse systemic risk? After all, the most credible information about mortgage defaults are spread throughout the local housing markets in the various states of the United States. So if the finance industry had been decentralized, it would have been in a much stronger position to take into account the data from the foreclosures and the falling house prices around the country.
Another important reform needed in the finance industry is to find ways for it to function apolitically and secularly. If the wealth that the finance industry creates would vanish at the first hint of turbulence, even in a favorable political environment like America's, how can one expect to export American financial technology to the world? This is the great challenge for modern finance theory, to figure out which parts of the theory depend on political favors to succeed, and to investigate to what degree are political favors important. These are major challenges for finance theory. The finance industry needs to address these issues in its day-to-day professional practices. Professor Stiglitz is well aware of the undue political influence exerted by the financial system. In fact, he has been writing about it for over a decade now.
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