[Lazy Quote Comment]

Here is the "Lessons for Economics" portion of the talk.  NBBook's analysis, "Stiglitz ends with a criticism of the economics profession that is almost vicious in its directness, lucidity and intensity" is spot on.  The only adjective to add is "devastating."  While, to a reader of ET, its nothing we haven't seen before Stiglitz does provide a (relatively) short, easily grasped, precis of our discussions over the last three years.

It's a Public Service, one supposes.

Let me spend just a few minutes talking about the lessons for economics. The Great Depression
transformed the economics profession. Even as the economy sunk into depression, mainstream economists argued that nothing should be done, as government intervention would only make things worse.  As the Depression faded into distant memory, the economics profession lost sight of these lessons.  Dogmas and doctrines holding that markets worked well and that they were self-correcting once again came to predominate. This time, the theories were more sophisticated, but the underlying assumptions were equally irrelevant. These ideas helped shape the intellectual milieu that gave rise to the flawed policies that in turn gave rise to the current crisis.  To some extent, they are shaping policies today as we attempt to respond to the crisis.

The advocates of free markets in all their versions say that crises are rare events, though they have been happening with increasing frequency as we change the rules to reflect beliefs in perfect markets. I would argue that economists, like doctors, have much to learn from pathology. We see more clearly in these unusual events how the economy really functions. In the aftermath of the Great Depression, a peculiar doctrine came to be accepted, the so-called "neoclassical synthesis." It argued that once markets were restored to full employment, neoclassical principles would apply. The economy would be efficient. We should be clear: this was not a theorem but a religious belief. The idea was always suspect.

Why should market failures only occur in big doses? Rather, recessions can be seen as the tip of the iceberg.  Underneath, there are many smaller market failures giving rise in aggregate to huge inefficiencies -- illustrated, for instance, by the myriad of tax paradoxes. We should remember, too, that while megafailures have been rare in the United States, on a global scale such failures have in fact been frequent. This is just the largest, most recent of the financial crises that have occurred since America's savings-and-loan debacle or the bailouts with country names--Mexico, Brazil, Korea, Indonesia, Argentina, Thailand, Russia--which were really bailouts of Western lenders as a result of the inadequate assessment of creditworthiness.

The main difference between these crises and the current one is, the consequences were felt in the periphery, and the cost of bailouts was largely borne in the periphery. The irony, of course, was that other strands of modern economic theory, including the theory of imperfect information, were simultaneously explaining why markets often do not work so well.  Bruce Greenwald and I, in Towards a New Paradigm in Monetary Economics (2003), showed that the reason Adam Smith's invisible hand often appeared invisible was that it wasn't there. Market equilibria were not Pareto-optimal whenever there were information imperfections, and asymmetries, and imperfect risk markets. That is always. At the same time, the most successful countries ever in terms of growth and poverty reduction, the countries of East Asia, follow policies with active government involvement.

One would have thought that this powerful combination of theory and evidence might have dampened the enthusiasm for unfettered and under-regulated markets, but evidently it did not. I understand the unbridled enthusiasm of special interests that found the arguments for deregulation profit enhancing.  I'm not so clear on what motivated so many economists.  

Some have argued that risk is the price we have to pay for innovation, and America's financial markets have been extraordinarily innovative. However, financial markets did not create risk products that would have enabled individuals to manage the risk they faced: the simple risk of homeownership. Rather, the innovations consisted mostly of tax, regulatory, and accounting arbitrage. Their financial alchemy--converting F-rated toxic mortgages and financial products that could be held by fiduciaries--had a private, but not necessarily social, payoff.  

Such repackaging, we know from the Modigliani-Miller theorem, should have a limited value.  Meanwhile, many in the financial sector actually resisted innovations that would have made markets work better--innovations like GDP, inflation index bonds, Danish mortgage bonds, and better auctions of Treasury bills. The models that are predominating within macroeconomics, which assume representations with rational expectations, are particularly disturbing. These models have particular influence among central bankers. If I were giving my litany of criticisms of the central bankers, I would say they should have begun inflation targeting and with the models that they have, which are actually badly flawed.

What I find even more striking is that some economists still argue that this crisis has not shaken their belief in rational expectations. To me, the evidence of irrationality and intellectually inconsistency abounds--I can give dozens of examples. It's just astounding.

Even today, flawed thinking continues. We are encouraging mergers among the big banks that cause them to be even bigger. We talk about tight regulation of systemically significant institutions, failing to note that there can be systemic effects of correlated behavior on the part of institutions, even if each is not systemically significant.

Representative Asian models that have dominated the economics professions ignore the rich diversity of our economy, a diversity that is at the heart of some of the problems it faces. An economy with a single individual has no lenders and no borrowers, no problems of asymmetric information (unless individuals are subject to schizophrenia), no need for banks, no need to ascertain creditworthiness--in short, it is missing everything that is important. Remarkably, much of the economics profession focused on models that have almost nothing to say about the crisis we are facing. And there were those who were pursuing alternative strands of thought. Among these was Hyman P. Minsky, who this conference is honoring.  I had the good fortune of knowing him quite well, and he pushed using macroeconomic models.  So there were alternative models out there, but they were systematically ignored by much of the economics profession.

Hopefully, we will learn, at least for a while, some important lessons from this crisis. Unfettered financial markets do not work, and the current regulation and regulatory institutions failed, partly because one is not likely to get effective regulation when there are regulators who do not believe in regulation.  Markets are not self-adjusting, at least within a relevant time frame.

More broadly, Darwinian natural selection may not work either. Rather, like Gresham's law, which holds that bad money drives out good, reckless firms forced more conservative firms to follow similarly reckless investment strategies. More prudent firms might have done better in the long run, but they could not survive to take advantage of that long run.

Our financial system failed in its core mission, allocating capital and managing risk, with disastrous economic and social consequences--not just in misallocated capital in the past but also in the huge disparity between potential and actual GDP in the coming years, sums that almost surely will be in the trillions of dollars. Regrettably, flawed economic theories aided and abetted both those in the public sector and those in the private sector in pursuing policies that almost inevitably led to the current calamity.

We need to do a better job of managing our economy, but this will require better research that is less framed by the flawed models of the past, less driven by certain simplistic ideas, and more attuned to the realities of today. There is a rich research agenda ahead.

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

The cumulative price to the average citizen of the USA of financial bailouts since the Savings and Loan Fiasco of the '80s and through the current catastrophe may not yet exceed the cumulative cost of US military spending, but if it does not yet it soon will.  The Financial Disservice Industry first takes a healthy bite out of this money to cover bonuses and then uses the rest as required to paper over the immediate consequences of bad investments.  Were they to actually resolve the problems they would be killing the goose that is laying the golden eggs.

Clinging to a failed economic paradigm whose chief value is the rhetorical cover it provides for their rapacious behavior serves to de-legitimate analysis that might ward off some of these repeated failures.   It might be thought that this is a major deficit of that system, but, increasingly, it seems that that is the very point of Mainstream Economics as practiced in the USA.

"It is not necessary to have hope in order to persevere."

Glad you posted this here. I saw your link at dKos, but there's such an overwhelm of stuff sometimes that it's hard to focus in on individual long posts.

And besides, I find I prefer to read in-depth items here, anyway. :-)

Reading through the PDF makes me angry.  Stiglitz is clearly stating things that have been clearly stated on ET for the last year.  Yet these fundamental criticisms have not made it into the public sphere.  Why not?

The simplest explanation that accounts for the observed phenomena is the best.  For this I nominate Upton Sinclair:

It is difficult to get a man to understand something when his job depends on not understanding it.

Almost all economists who work in government or for economic organizations representing the interests of the majority of the holders of wealth are incapable of "understanding" the true nature of the current system as their jobs depend on not understanding it.  The purpose of Mainstream Economics is to provide a "cover story" that is useful for disguising what, if understood properly, clearly should be illegal.

NBBooks was right a year ago: Wall Street must be euthanized!  

This is necessary but is not sufficient to a proper solution to this crisis.  The "rent" that is being extracted from the economy by the financial sector is a millstone around the neck of the economy.  Trying to make good the losses of Wall Street on their counterfeit wealth will preclude any real recovery.  So long as Wall Street and, especially, Goldman Sachs, retain the stranglehold over US economic policy which their ill gotten gains have given them, no one who can "understand" the true nature of the problem will be allowed any place in the public discussion.  Goldman and others on Wall Street must die so that the economy may live!  

There is no alternative. While they remain, they will prevent even the consideration of any meaningful change. The chief beneficiaries of a fatally flawed system are always the last to recognize those flaws and do so only when the system has publicly and undeniably failed.

The unenviable and daunting task of making this known to the wider public falls to us and others who are like-minded.  Else we face a very dark future.        

"It is not necessary to have hope in order to persevere."