All Commentary
Wednesday, January 4, 2012

Freefall: America, Free Markets, and the Sinking of the World Economy

In 2001 Joseph Stiglitz was co-recipient of the Nobel Prize in economics, a fact prominently noted on the dust jacket of Freefall, his book on the financial crisis. In 2002 Stiglitz and two coauthors produced a report, commissioned and published by the government-sponsored housing agency Fannie Mae, stating that the risk of a failure by Fannie Mae was “extremely small”; indeed, “under the assumptions they adopted, the risk to the government from a potential default on GSE [Fannie and Freddie] debt is effectively zero.” That report is mentioned nowhere in Freefall.

In 2008 Fannie Mae (and its sibling, Freddie Mac) both failed. Their debts were assumed by the federal government. The loss imposed on taxpayers was recently estimated by the Congressional Budget Office at $325 billion through 2011, with additional losses to come.

In the above-mentioned report Stiglitz and his coauthors noted the view that there was an implicit government guarantee that enabled Fannie and Freddie to borrow at below-market interest rates. Their estimates of taxpayer risk were based on the assumption that “the implicit government guarantee on GSE debt is equivalent to an explicit guarantee.” In Freefall, by contrast, Stiglitz declares, “Fannie Mae began as a government-sponsored enterprise but was privatized in 1968. There was never a government guarantee for its bonds; had there been, its bonds would have earned a lower return, commensurate with U.S. Treasuries.”

That statement is seriously misleading. Fannie (and Freddie) had an all-but-explicit guarantee and received other favored treatment from the government. Reflecting the implicit guarantee, their bonds paid lower yields than those of other private financial institutions. Their borrowing-cost advantage was worth billions per year.

The misleading treatment of Fannie Mae and Freddie Mac is just one example of a pervasive feature of Freefall: It often traffics in ideological spin. Stiglitz notices the mote of ideological bias in the eye of “those who have done well by market fundamentalism,” but ignores the beam in his own.

Free of false modesty Stiglitz describes himself as a member of “a small group of economists” who in the years before 2008 “tried to explain why the day of reckoning that we saw so clearly coming had not yet arrived.” He views himself as a courageous outsider, but it is difficult to share Stiglitz’s outsider picture of himself in light of the well-placed insider roles he has occupied during his career: chairman of the President’s Council of Economic Advisers (1995–97) and chief economist at the World Bank (1997–2000).

A major theme of Freefall is that incentive-distorting government regulations had little to do with the financial crisis. The plot line of his narrative is indicated by the title of chapter six: “Avarice Triumphs over Prudence.” The crisis happened in a “deregulated market,” or a market characterized by “lax regulation,” and so “it was something that Wall Street did to itself and to the rest of society.” He writes of “the deregulatory frenzy of the 1980s, 1990s, and the early years of [the 2000s],” and “the current rush to deregulation,” events not evident in the actual historical record.

Stiglitz makes his case for government intervention by holding free markets to the straw-man standard of frictionless efficiency. He touts his own academic research as showing that when the conditions for perfectly frictionless efficiency are not satisfied, “there [are] always some government interventions that could make everyone better off.”

This is argument by existence proof: The brief for government intervention is that we can imagine a case in which it improves things. It could make everyone better off—assuming an ideally omniscient and benevolent intervener. Might not actual government interveners fail to meet the conditions for their own perfection? Might they fail to know just where and how to intervene?

At least Stiglitz recognizes that government policies played a crucial role in creating the housing bubble. He notes that the Federal Reserve’s loose monetary policies under Greenspan fueled the housing boom and acknowledges the role of the moral hazard fostered by too-big-to-fail policies. He points out the cronyism involved in bailouts to Wall Street, particularly from the Federal Reserve Bank of New York.

Stiglitz offers a straightforwardly Keynesian analysis of the Great Recession, blaming it on insufficient aggregate demand. Therefore the government should “attack with overwhelming force” in the form of massive stimulus spending, an approach he suggests might be called “the Krugman-Stiglitz doctrine.”

Overall the book is a patchwork of nonscholarly accounts of historical events beside attempts to render scholarly economic theories into plain language. In many places the book disappointingly reads as though the author lacked the time to state his case systematically and coherently, to anticipate the strongest objections to his arguments and state them fairly, then address them carefully with evidence.