Review of "Freefall" by Joseph Stiglitz

Freefall by Joseph Stiglitz:

Even if one disagrees with Stiglitz's ideological biases, this exposition of recent economic events is excellent, both accurate and fair in its criticisms. Stiglitz also provides a good discussion of the trade imbalances that afflict the world economy, as globalization is his specialty. Best is the challenges he presents to his fellow economists. But it's not without its blemishes. Since I have given the book five stars I will skip over the kudos and address its weaknesses.

Stiglitz sets up a weak strawman in market "fundamentalism," as most serious free market advocates eschew dogma and see a limited role for government, especially to insure open and competitive markets. Stiglitz himself admits the dominant role of markets and only argues for a subjective "balance" between govt regulation and markets. This continuum can be freely debated, as many of the recent market failures stemmed from circumventing free market principles. Most of the violations Stiglitz cites boil down to inside actors using political or economic power to secure "heads we win, tails you lose" outcomes. This is what happened across the banking system as we privatized the returns and socialized the risks with bailouts. A functioning market economy relies on trust and must prevent blatant violations of the rules of voluntary exchange. Thus the crisis was not a repudiation of free markets, it was both a failure of risk management and a warning regarding the abuse of market principles.

The policy debate over govt regulation too often slips into the idea of the regulatory bureaucrat rather than the dynamics of self-regulation based upon competing interests. Our political democracy relies on competing interests and a governing structure for checks and balances, with minimal monitoring. Our market structures should strive to do the same with competitors policing each other. Stiglitz mostly steers clear of this distinction while conceding that much of the blame for the financial crisis was the agency problem that befell not only the private sector, but also the public sector. Regulatory "capture" is a serious concern for regulating the financial sector.

Stiglitz correctly castigates the Bush and Obama administrations for laxness and ineptness in managing the crisis, but whitewashes the Clinton years, when much of the financial deregulation was enacted. The Clinton regime was instrumental to the Democratic courtship of Wall Street and Stiglitz himself was a prominent Clinton economic adviser. Obama has picked up where Clinton left off, reappointing many from his team. (Hope and change turned out to be more of the same.) For its part, Wall Street is an equal opportunity player in Washington.

The most controversial issue is probably Stiglitz's unwavering support of Keynesian demand stimulus. There is reason to suspect this cure-all for a deflating economy, but Stiglitz dismisses all doubts. However, the effectiveness of demand stimulus depends on the Keynesian multiplier, which in turn depends on a healthy banking system extending credit in response to credit demand from the private sector. In the aftermath of a debt deflation, both of these conditions fail in robustness. With a balance sheet recession, it may well be that the Keynesian multiplier is closer to zero than the hoped for 1.5. Another way to look at this is that Keynesian policies may be appropriate after a collapse in prices due to massive deleveraging but much less effective in preventing that collapse. The Japanese experience suggests that propping up a zombie banking system can dangerously prolong the post-bust correction. In this context the Fed's policy of reflation is likely to yield more crippling asset bubbles.

The most productive discussion is when Stiglitz turns on his fellow economists. His criticism of the dominant neoclassical paradigm is spot on, especially when it comes to macroeconomic theory. Our current macropolicies are so confused because our theoretical tools are less useful in a nonlinear world and this is especially true in the world of finance. Rational actor assumptions have limited value in a real world where people are loss averse, heterogeneous and adaptable in their preferences, and show a tendency to herd behavior. Our most intractable policy problems are those of skewed or maldistributions, whether they be income and wealth inequality, global warming, health care, hunger or energy. Mathematical models based on fixed preferences, simultaneous equations, and equilibrium conditions are not amenable to distributional dynamics. Thus, the solution to inequality always regresses back to initial conditions, like education or material endowments. Instead, our policies should be addressing the access and distribution of financial capital and the dynamics of our financial markets. The rich are getting richer off their leveraged capital and political influence, not their good looks or brains.

Given that managing uncertainty may be the best we can do in public policy, Stiglitz correctly argues for the dominant role of risk management. But he also fails to consider how risk and uncertainty is most effectively managed through decentralization and diversification. This is accomplished through wide and deep markets. Social insurance pooling may be an important corollary to private risk management where private markets are incomplete, but is far less efficient and prone to unmanageable moral hazard costs. Think how many would choose to cash in their 401(k) or private pension for Social Security promises, or their private health insurance for Medicare? The bottom line is that health care and retirement funding are private goods and forcing them into the public goods model only hampers their production and distribution. We may need a safety net, but that's as much as the empirical data supports. Entitlement reform will require private substitutes and this makes it critical we insure that markets function as intended. This may be the best argument for financial market reform.

I suppose one could write a book instead of a review, but Stiglitz has already written one that offers the reader much food for thought. I suggest not taking anything for granted, as Stiglitz has his own ideological agenda to hoe. But he does a very commendable job in debunking much of the partisan-motivated bloviating.