Joseph Stiglitz: Why we have to change capitalism

[Ghost Dog]

In an exclusive extract from his new book, Freefall, the former World Bank chief economist, reveals why banks should be split up and why the West must cut consumption.

... snip from long article ...

... In the current crisis, bankers lost our trust, and lost trust in each other. Economic historians have emphasized the role that trust played in the development of trade and banking. The reason why certain communities developed as global merchants and financiers was that the members of the community trusted each other. The big lesson of this crisis is that despite all the changes in the last few centuries, our complex financial sector was still dependent on trust. When trust broke down, our financial system froze.

It's easy to curtail excessive risk-taking: restrict it and incentivise banks against it. Not allowing banks to use incentive structures that encourage excessive risk-taking, and forcing more transparency will go a long way. So too will requiring banks that engage in high-risk activities to put up much more capital and to pay high deposit insurance fees. But further reforms are needed: leverage needs to be much more limited and restrictions need to be placed on particularly risky products.

Given what the economy has been through, it is clear that the federal government should reinstitute some revised version of the Glass-Steagall Act. There is no choice: any institution that has the benefits of a commercial bank – including the government's safety nets – has to be severely restricted in its ability to take on risk.

There are simply too many conflicts of interest and too many problems to allow commingling of the activities of commercial and investment banks. The promised benefits of the repeal of Glass-Steagall proved illusory and the costs proved greater than even critics of the repeal imagined. The problems are especially acute with the too-big-to-fail banks.

The imperative of reinstating the Glass-Steagall Act quickly is suggested by recent behaviour of some investment banks, for whom trading has once again proved to be a major source of profits.

The alacrity with which all the major investment banks decided to become "commercial banks" in the fall of 2008 was alarming – they saw the gifts coming from the federal government, and evidently, they believed that their risk-taking behaviour would not be much circumscribed. They now had access to the Fed window, so they could borrow at almost a zero interest rate; they knew that they were protected by a new safety net; but they could continue their high-stakes trading unabated. This should be viewed as totally unacceptable.

There is an obvious solution to the too-big-to-fail banks: break them up. If they are too big to fail, they are too big to exist. The only justification for allowing these huge institutions to continue is if there were significant economies of scale or scope that otherwise would be lost. I have seen no evidence to that effect. Indeed, the evidence is to the contrary, that these too-big-to-fail, too-big-to-be-financially-resolved institutions are also too big to be managed. Their competitive advantage arises from their monopoly power and their implicit government subsidies.

This crisis has exposed fissures in our society, between Wall Street and Main Street, between America's rich and the rest of our society. While the top has been doing very well over the last three decades, incomes of most Americans have stagnated or fallen.

The consequences were papered over; those at the bottom – or even the middle – were told to continue to consume as if their incomes were rising; they were encouraged to live beyond their means, by borrowing; and the bubble made it possible. The consequences of being brought back to reality are simple – standards of living are going to have to fall.

Someone will have to pick up the tab for the bank bail-outs. Even a proportionate sharing would be disastrous for most Americans. With median household income already down some 4pc from 2000, there is no choice: if we are to preserve any sense of fairness, the brunt of the adjustment must come from those at the top who have garnered for themselves so much over the past three decades, and from the financial sector, which has imposed such high costs on the rest of society. ...

/... http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/7061058/Joseph-Stiglitz-Why-we-have-to-change-capitalism.html