A former chief economist at the World Bank, Joseph Stiglitz was awarded the Nobel Prize for Economics in 2001. His latest book, Freefall, examines the causes of the recent global financial crisis and suggests that radical reforms are needed to prevent similar sytemic crises in the future.
The label everybody uses to describe you is “Nobel prize winning economist”. What did you earn the prize for?
I got it for explaining how economies work when there’s imperfect information, or more specifically asymmetric information, which is when somebody knows something that other people don’t. For the hundreds of years before my work, economists had assumed perfect information. They knew it wasn’t true but hoped that it wouldn’t change the conclusions too much. I developed frameworks for thinking about imperfect information, and discovered that imperfect information makes a big difference.
Do you remember where you were and how you felt when you received the phone call telling you you’d won the prize?
Yes. I was at home in our apartment, and a reporter had asked whether I would like to be woken at four o’clock in the morning to comment on his belief that somebody else was going to get the Nobel prize that year. I was not very enthusiastic, so I said no. When I woke up I discovered that they’d postponed the announcement until 10am. At about 9.30am I got a call, and the person making the call from Sweden made a big point of turning the receiver over to the person who I knew was on the Nobel prize committee, so that I knew it wasn’t a hoax. At that point we switched from drinking coffee to drinking Champagne.
One of the economists who shared the prize with you, George Akerlof, another imperfect information theorist, has also been prominent in writing about the crisis. Is that a coincidence or is the crisis all about imperfect information?
George was my best friend at graduate school, so the fact that we began talking about these issues together in 1964 means it’s not a surprise that we’re thinking in similar ways. I wrote my new book, Freefall, because the crisis was like a textbook case of what I had been saying all along. There had been a school of economics, sometimes called the Chicago School, that believed that markets were efficient, that information disseminates very quickly. My research has shown that that was not the case, and what has happened is certainly a manifestation of the massive, massive consequences of those imperfections.
This crisis. In a nutshell, what happened?
The same as happened in many other crises. There was a bubble. The bankers, who were supposed to be managing risks, allocating capital, gathering information, processing information, instead of doing their job well, fed the bubble and fed it in a way that repeatedly demonstrated irrationality, you might say stupidity, of a very high order.
As an academic I like to focus on some of the obvious intellectual incoherence of what they did. For example, while real incomes of most Americans were going down year after year, house prices were going up and up and up. Well, it’s very clear that that process couldn’t go on forever.
You’re very critical of the bank bailouts worldwide and particularly in the US. Why?
The main reason is that the bailout failed to do what it was supposed to do, which is rekindle lending. It gave money unnecessarily to the banks without getting anything in return, the result of which is that we have a much bigger national debt than we otherwise would have had, if we’d done it better. And we didn’t have any vision of where we wanted the financial system to go, so we’ve wound up with a more distorted financial system with more weight on the gambling institutions and less weight on the institutions that actually create a better economy. Because we bailed out the banks, and not just the banks but the bankers, shareholders and bondholders, we enhanced the problem of moral hazard — we created a system of ersatz capitalism where we socialised the losses and privatised the gains.
If President Obama called and asked you to take over at the Treasury, would you say yes? And what would you try to achieve?
Let me first answer the second question. I would begin by asking what we want a financial system to do. We want a financial system that lends to businesses, especially small and medium sized enterprises, helps promote venture capital — all of those things.
Then think of the impediments. As an economist you first begin to think about incentives. Our system has bad incentives: organisations are too big to fail, too interconnected to fail, too correlated to fail. You try to attack those sets of issues, breaking up the banks, restricting the kinds of activities they can do, restricting the scope for conflicts of interest and so forth.
And then individual incentives for short-sighted behaviour and excessive risk-taking. We also need improved corporate governance, better tax policy and increased transparency. You won’t ever achieve perfection, but we can do a lot to make a recurrence less likely.
And would you take the job?
The diplomatic answer is that I’ll cross that bridge when I come to it. It’s very difficult for anyone to turn down a request from the President, especially if you’ve been arguing that you know what needs to be done.
What surprised you most about the crisis?
I’ve never believed that markets are self-correcting or that people are perfectly rational, but the level of stupidity and risk that they took… it’s just mind-boggling.
You seem to present yourself as a bit of an enfant terrible of economics, but the truth is you have the Nobel prize, every student reads your early research, and I don’t think it’s accurate to portray you as anti-globalisation or anti-capitalist. Are you worried that you’re giving comfort to radical market sceptics who don’t really understand or agree with your real beliefs?
The way I see it is a little bit like the way I see Keynes. He was trying to save capitalism from the capitalists. Had Keynesian economics not succeeded in showing that you could restore near-full employment, the attacks on capitalism would have been virulent. Had the so-called “capitalists” had their way and engaged in budget cutting, there would be no capitalism. I guess I feel a little bit the same way…
That’s not a modest comparison.
I didn’t mean it that way! But to put it even more “modestly”, I have a broader agenda. Keynes had one issue on his mind: full employment. I have many more issues. Keynes and his successors argued that once you were at full employment, markets were efficient. My claim is that even at full employment, markets can be inefficient, and even when they’re efficient, they may not be fair.
I view the market as an instrument. I think it’s a very powerful, effective instrument, but it can be used for good or evil. It has to be shaped to be used for the positive, and the shaping is a political process. I think the anti-capitalists who are seeing the adverse effects typically don’t have an alternative instrument. All they see is that capitalism as it is being used leads to outcomes that they find unacceptable. To some extent I agree with them, but I don’t blame the tool. You can use a hammer to kill somebody, but it’s still a hammer that can be used to build a house. You don’t destroy the instrument, you ensure it’s used the right way.
You seem to think that this crisis presents us with an opportunity. What is that opportunity?
It’s an opportunity to, at the very deepest level, reform capitalism. Capitalism before the great depression and after was very markedly different. We need another change to the rules of capitalism. The flaws have been brought out into the open and therefore there’s an opportunity to focus on those and to do something about them. But the forces that resist those changes are still there. Right now it doesn’t look like many of the changes will occur but at least in the United States there’s a growing backlash — so it’s wide-open right now where we’re going to go.
Freefall is published by Allen Lane, £25.
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