On Freefall #1

In this book, Joseph E. Stiglitz provided a holistic and in-depth analysis of the 2008 Great Recession. In this post (and many following ones), I would like to recapitulate the main theses of the book with my interpretations.

The causes

Many critics and commentators held Wall Streeters, and in particular their insatiable greed, responsible for this economic epidemic. However, Stiglitz believed that Wall Streeters were no greedier than an ordinary American. He saw far deeper causes than greed - a part of human nature.

1. Misaligned Incentives. This is a fundamental problem underlying many other problems in the financial sector. The banks and other financial intermediaries were supposed to be the middlemen between lenders and borrowers, easing the process of searching and matching and providing some basic functions such as credit assessment. However, these financial institutions had no incentive to ease this process by reducing transaction costs because these costs were indeed revenues for them. One such example was the failure to provide an efficient Electronic Payment System which was absolutely viable given the current advancement in technology. Similarly, mortgage dealers, who saw extra profits from collecting mortgage restructuring fees, would encourage borrowers to take on mortgages beyond their ability to repay and later offer them mortgage refinancing.
2. Conflicting Interests. When commercial banks were allowed to merge with investment banks, a severe problem of conflicting interests arose. Typically commercial banks should be more risk averse since they were responsible for their depositors' savings. On the other hand, investment banks tended to be more risk taking as they sought more profits. When these two different types of banks merged, the new entities, with more funds to play with, often undertook many gambling behaviors, putting depositors' money at stake.
3. Ill-conceived Financial Innovations. Innovations were supposed to bring more good than evil to the society as a whole. In particular, financial innovations should help people manage risk better and make the process easier. However, due to the mismatch between duties and incentives of the financial institutions, many complicated financial innovations such as collateralized debt obligations (CDO) and credit default swaps (CDS) in fact increased the risks enormously (due to the hidden systematic risks that were not accounted for by their ratings) and rendered risk assessment almost impossible (due to their complexity). These innovations helped build record high accounting profits, but the institutions' actual positions were elusive.
4. Deregulation. Since Clinton's term, special interest groups in the financial sector had gained enough political power and successfully shielded the industry from governmental scrutiny. Furthermore, the regulators of the various financial institutions were themselves from Wall Street; they often shared a common interest with those being monitored. This lack of effective regulation made possible all these crafty innovations and mergers of commercial and investment banks on top of many illicit fraudulent behaviors.
5. Loose Monetary Policies. Federal Reserve had long kept the interest rate at low level, flooding the economy with liquidity. This discouraged savings and encouraged more risky investments. In particular, financing through mortgage and mortgage restructuring appeared very lucrative when the interest rate was low, and helped sustain a normally unsustainable level of consumption.
6. False Belief in Free Markets. The fervent belief in free markets was the ideological cause of this crisis. Free market fundamentalists were predominant in both Wall Street and Washington D.C. They supported the deregulation movement which eventually led to an over-sized, inefficient and irresponsible financial sector.