What's the Banking System Really For?

A new book by Joseph Stiglitz lays out the case for fundamental financial reform to prevent future meltdowns.

By CSRwire Contributing Writer Francesca Rheannon

On March 7, voters in Iceland chorused a resounding "No!" to covering the losses to foreign depositors caused by the failure of the Icelandic bank, Icesave. The referendum -- which would have cost each citizen $16,400, had the measure passed -- was rejected by some 90% of those casting ballots. As one voter put it, "We don't want to pay for a system that isn’t working." (The victory may end up being a Pyrrhic one, since Iceland’s membership in the EU may be held hostage to brokering some deal on the bank losses.)

Icesave drank the same Kool-Aid that the big American banks did: pushing arcane, highly speculative investment instruments that toppled like a house of cards when the popping of the U.S. housing bubble triggered the global meltdown. Covering the bank's total debt would cost Iceland 45% of its 2009 economic output, bankrupting the nation. American taxpayers are on the hook for even more in rescuing our big banks: some $12 trillion -- or 80% of GDP -- if you count all guarantees and bailouts promised or given out by the U.S. government.

Americans weren't given a choice to vote on the bank bailouts or guarantees and plenty of them are mad as hell about it. Many economists, however, are wiping their brows in relief, believing that had the bailouts not happened, the whole economy would have tanked even worse than it did. And things are looking up: the economy grew at an increasing pace in the last quarter of 2009 and first quarter of 2010, some banks have paid back the bailout money and it seems the U.S. economy is back on track. (Of course, with the official unemployment rate still hovering around 10%, long term unemployment prospects at a dismal high, and home foreclosures on "involuntary acceleration," you can forgive those who ask, "Recovery? What recovery?")

But in his new book, FREE FALL, Nobel Prize-winning economist Joseph Stiglitz cautions it's too soon to break out the bubbly. And that's because, he says, the system isn't doing its basic job: to direct capital efficiently where it's needed in a way that "helps households and corporations alike to manage risk and provides the basis of a fast and low-cost payment system." In other words, to efficiently grease the wheels of the real economy at an affordable cost to borrowers.

Stiglitz shoots down a number of free market shibboleths: that unregulated markets are efficient and that the deregulation of the banks promoted innovation and increased productivity. It's not that he doesn't like markets: he says they "lie at the heart of every successful economy." But he says that they don't work well on their own, because they don't provide perfect information (e.g. between mortgage lenders and borrowers), and they lack incentives for properly calculating risk.

The incentives issue is key - and Stiglitz ties it to a mismatch between social and private returns. Take innovation: instead of the banks nurturing the incubation of a clean energy economy with good domestic green jobs (which would have improved both short and long term economic stability and decreased risk to lenders) they poured their innovative energies into casino-like financial instruments that raked in big fees for bank managers.

With major banks "too big to fail" and the U.S. taxpayer perennially on the hook for bailouts, the moral hazard has only grown. Stiglitz faults the Bush Administration for the way the initial bailout was structured, but says the Obama Administration has been no better. It has failed to restructure the banks to bring them in line with market realities and increasing the likelihood of future financial crises. Market discipline is emasculated, imprudent risk-taking is rewarded, and capital markets are distorted to favor the reckless big players over more prudent small banks. And the real economy is starved of lending capital while the money goes into dividends and bonuses.

Stiglitz says government must institute fundamental financial reforms: increase transparency by bringing in mark to market accounting; disincentivize risk by linking base pay of bank executives to long term performance (this would help shareholders, as well), regulate derivatives, and end predatory lending practices. (He's in favor of a "Financial Safety Product Commission.")

But Stiglitz goes beyond reforming the financial system to stressing we have to restructure the economy, as well. He says we need to shift the balance from finance and real estate to sustainable sectors like clean energy. We have to invest in human capital, not just through education, but also by creating full employment, guaranteeing social protection and preventing exploitation. Stiglitz says accomplishing this will take shift in values toward putting moral responsibility at the center of economic thinking.

An example of that kind of thinking can be seen in a creative solution just proposed to Iceland's debt dilemma. Gijs Graafland, a Dutch analyst for the Planck Foundation, has come up with a novel solution: bartering Iceland's geothermal energy to Europe in return for writing off Icesave's debt. (Thanks to Hazel Henderson for alerting me to this proposal.) He says this would build "a solid, sustainable economy in Iceland based on harvesting geothermal energy under the banner of boosting Europe's energy diversity and security." That's the kind of financial innovation the world could use more of.