Joseph Stiglitz
Council of Economic Advisers (1993-1997)

Interview: Joseph Stiglitz

“The reason that the invisible hand seems invisible so often is that it's not there. Markets are often not efficient.”

Winner of the 2001 Nobel Prize in Economics, Stiglitz was a member and then chairman of the Council of Economic Advisers (1993-1997) and senior vice president and chief economist of the World Bank (1997-2000). This is the edited transcript of an interview conducted on July 28, 2009.

Could you give me a sense of the economic, financial worldview that was happening in Washington and on Wall Street during the '90s?

I was a member and then chairman of the Council of Economic Advisers in the Clinton administration from '93 to '97. Then I went to the World Bank as chief economist. And so we were very much involved in all of these debates on what was the right role of government.

The Clinton administration was very interesting because it was very divided. There were those like [then-Secretary of Labor] Bob Reich that wanted a very strong government role. There were those like [Treasury Secretaries] Bob Rubin and Larry Summers who were very much for deregulation, getting government out of interventions in the market. And I was somewhere in between these two schools. I believed very strongly that the market has an important role to play, but I also knew that unfettered markets were a disaster, and there had been a long history of problems of deregulation, liberalization, free banking leading to disaster. ...

Very soon after I came to Washington, we began having these debates. They took place both in the domestic and in the international arena. In the international arena, the key issue was capital market liberalization, whether we should use our influence, our power, to force countries like Korea to liberalize its capital markets, to liberalize their financial markets, to open themselves up to derivatives.

Many of us thought that it was not the role of the government to make the world safe so that Goldman Sachs could sell derivatives in Korea; that, in fact, these derivatives were highly risky, particularly for countries that were not at a more sophisticated stage of development and that we should not be intervening in their economic policies. ... And so that was one of the first major controversies that we had. It was both a controversy about the role of the U.S. in the international arena, but also the role of government in financial markets in the liberalization agenda.

The next issue that came very much to the fore was the issue of repealed Glass-Steagall Act. While I was chairman of the Council of Economic Advisers, that didn't go through. It happened after I left. I opposed it very strongly. I thought there were good reasons why we had passed Glass-Steagall in the aftermath of the Great Depression. You look at the history, and it was clear that the quarter century after World War II, in which we had strong financial market regulations, is that one quarter century in the world in which there was almost no financial crises, no banking crises. It was also the period of most rapid economic growth, and it was also the period in which the inequalities in our societies were being reduced. So it was very hard to say that these regulations had stifled economic growth.

Where was that impulse coming from?

Oh, it's very clear. The impulse was coming from the financial markets. You have to remember, the secretary of Treasury [Rubin] had been the head of Goldman Sachs, the largest investment bank, and he went on to become one of the chief executives of Citibank, the largest commercial bank. Very clear that there were strong economic incentives for mergers.

But there were three questions that we raised. The first was, "What are you going to do about the conflicts of interest?" The response they gave was, "We'll create Chinese walls." But then I asked: "If you have the Chinese walls, why bring them together? Where are the economies of scope?" And in fact, as we looked at it, I thought you could see lots of problems but very little benefits to the economy as a whole.

Those fears of conflicts of interest, those fears that the Chinese walls would be very low, turned out to be the case, and we saw that in the WorldCom, Enron scandals the beginning of this decade. ...

But there were two other problems. One of them is that by breaking down these barriers, we would wind up with larger financial institutions that would reduce competition, increase the risk of too big to fail. Banks that are too big to fail have incentives to engage in excessive risk taking. And that's exactly what happened. The increase in the concentration in the banking system in the years after the repeal of Glass-Steagall has been enormous, and we've seen the excessive risk taking, which American taxpayers have had to pay hundreds of billions of dollars for.

And the third factor that I think was not fully appreciated at the time, but clearly is evident since, was that the culture of these two kinds of institutions is and ought to be very different. Investment banks take rich people's money and are exposed to undertake risk, which is appropriate to those seeking high returns but can bear the high risk. ... The basic commercial banks are supposed to provide finance to small and medium-sized enterprises. They are an essential part of the lifeblood of an economy. That kind of banking is supposed to be boring; it's supposed to be conservative; it's supposed to do the job of assessing risk and making sure capital goes to where it's supposed to go. ...

When you put them together, unfortunately what happened is the high-stakes, high-return culture of the investment banks dominated. And so what happened is the commercial banks, which had the security of deposit insurance, the backing of the U.S. government, in effect, dominated. And we wound up having to pay, as I said, hundreds of billions of dollars to rescue these commercial banks that engaged in excessive risk taking.

Otherwise our economy was going to melt down and evaporate?

That was the concern. Now, I think we went too far in some of these cases. We could have had a better structured bank restructuring. We didn't have to bail out the bondholders and the shareholders to the extent that we did; that's clear.

But in a sense, that is part of that whole story, because the big banks used their political influence to get deregulation; they used their political influence to stop initiatives for new regulations to restrict their excessive risk taking in derivatives; and not surprisingly, they then used their political influence to get this massive unwarranted transfer of money from the American taxpayers to them. ...

Now, there's a third issue that we dealt with in this period, and that was derivatives. It was just the beginning of the development of derivatives. We had many meetings, brought together all the regulators, including the chairman of the Council of Economic Advisers, which was not a regulator but is supposed to be a neutral observer of the whole economic system.

The consensus was that derivatives were a problem. The broad view of almost everybody in this group was that they were posing very great risk. Unfortunately, though, the dominant voice -- [then-Federal Reserve Board Chair Alan] Greenspan, people in the Treasury -- was there's nothing we could do about it; that it was too risky to try to stop this risk; that the intervening in the market would be a cure that was worse than the disease.

And so, not only did we allow these derivatives to continue to grow, but then we actually restricted the regulators from doing anything about it. This was in the period after I had left the Council of Economic Advisers and was over at the World Bank. ...

It was interesting that in the global economic crisis of '97 and '98, the IMF [International Monetary Fund], the U.S. Treasury, said hedge funds had nothing to do with this. They're too small; they couldn't have caused these kinds of problems. But then, when Long-Term Capital Management [LTCM] had a problem, they said the failure of one firm, one firm alone, cold bring down the whole financial system. Whether they were right or not, what is clear is that there was a perception on the part of many that there was a great risk, and the banks used their political influence to get a publicly orchestrated but privately financed bailout.

In the aftermath of that, there was a strong sense that we ought to do something about these derivatives, that they really were posing a risk to our national economy and to the global economy.

And what happened to that impulse?

The free-market advocates squelched it. There were too many people making money. ... The combination of the free-market ideology and the special interests was very powerful. ...

Backing up just a bit, you talked about the sort of bipolar nature of the economic advisers to President Clinton. ... Where was Clinton on the economy? Did he step back and let you guys sort it out, or did he have a real position one way or the other?

I'm not really sure. I think that as a, you might call it, a New Democrat, he wanted to distance himself from the excessive intervention of the New Deal. The New Deal had labeled Democrats as people who intervened in the market, and the New Democrats wanted to show that we were market-friendly. So in that sense, he was trying to distance himself from the past.

And to be fair, the financial markets, the economy, had changed a great deal since the New Deal, since the Great Depression, and we needed new regulations. We needed them in telecom; we needed them in many other areas. And in that sense, I was very receptive to these kinds of changes.

On the other hand, President Clinton did understand that there was a need for government. But I'm not sure he really understood exactly what those needs were. I think he was very open to these discussions.

In the end, he often remarked that he wished in the next life to be born as a bond trader. I think that reflected his view of where the political power lay, and also, to a large extent, let me say, the economic power. The political power obviously is campaign contributions and political influence in a whole variety of ways with Congress. The financial sector has five lobbyists per congressman and is one of the largest contributors to campaign finance, so clearly they are a big player in the politics.

But even in the economics, when markets are unhappy, stock markets can go down, interest rates can go up. If you are the president emerging from a recession, which we had in '91, '92, and you feel that recovery is not robust and you've been elected on a platform of jobs, jobs, jobs, it's the economy, stupid, you don't want to do anything to roil the economy. And if you were told by the financial wizards that doing such-and-such will roil it or doing such-and-such will calm it, you're going to pay some attention to that perspective.

So on that side are Rubin, Summers and Greenspan. ... How formidable are they? ... Greenspan -- who is he? What does he represent in this period of time?

I think the major protagonists, those who were pushing for this ideology, this liberalization, deregulation, not doing anything about the risk of derivatives, I think that they were a mixture. Greenspan, remember, always said that he was a believer in Ayn Rand, a believer in free market. Little bit curious for a central banker, because what is central banking? It's a massive intervention in the market, setting interest rates. So to me, that kind of perspective, to say, "I believe in free markets, but I'm going to accept the job at central banking," is a contradiction. You almost have to be schizophrenic.

The question is, what should be the interventions in the market? And we know we want some regulation -- how far do we go? And over the years, there's been a well-developed theory about when markets fail. We have a long historical experience and lots of economic theory.

Interestingly, some of the economic theory that was developed in the last quarter century -- my own work talking about what happens when there is imperfect information, which is, of course, at the centerpiece of financial markets -- explains that the reason that the invisible hand seems invisible so often is that it's not there. Markets are often not efficient. We can identify the nature of those failures -- not perfectly, but we can -- and say, "These are the instances in which we need government intervention."

And I think that many of these protagonists didn't really understand those basic economic ideas. They were wedded to, you might say, the outmoded ideas of free-market economics, which assume perfect information, perfect competition, perfect markets, perfectly informed market participants, no exploitation -- all assumptions that are totally irrelevant to a complex modern economy.

But it looked to them, as at first the tech bubble and then the housing bubble grew, with relatively little, from their point of view, government intervention, that in fact there was an invisible hand, and it was all good, and it was guiding us along, yes?

If they had thought about it for a minute, they would have realized that the visible hand of the government had been there over and over again. Just think about what the banks had done abroad. They had repeatedly, repeatedly viewed bubbles, misallocated capital, and government -- U.S. Treasury, IMF -- had repeatedly come and rescued them. We had the Latin America crisis at the beginning of the '80s, involving almost every Latin American country. We had the Mexican crisis in '94-95. We had the Korean crisis, the Indonesian crisis, the Thai crisis in '97. We then had the Russian crisis and the Brazilian crisis in '98. We had the Argentina crisis. The list is long, involving hundreds of billions of dollars, again, in government intervention.

So yes, the economy did work, but it was because the government kept bailing it out. It kept bailing out the financial sector. So they made a fundamental misinterpretation. ...

Let's go back just a little bit. I know you've left in '97. There is this woman, Brooksley Born, who takes over at the CFTC [Commodity Futures Trading Commission] in '97. Did you know her? Had you ever heard of her before she came into this obscure little agency?

No. I had been familiar with the CFTC because it had dealt with a couple of other problems. There was the ING [Barings] problem [with rogue trader Nick Leeson].

The little things, basically?

Well, that could have blown up. And as I say, I was involved in the LTCM crisis partly because of this incoherence between what the Treasury and IMF had said during the East Asia crisis and then what they then said just a year later. And it was clear that derivatives, this complicated, speculative risk taking, was at the core of it, and that what they had said was totally wrong in '97.

When [Born] decides to at least do a concept release [a report released to the public outlining a proposed rule change] and begin to ask questions about it, many people say a sort of nuclear reaction takes place. Rubin, Greenspan, Summers and [former SEC Chair Arthur] Levitt all jump in and say: "Absolutely not. This is a horrible idea. This is going to reduce the economy to something akin to what it was like just after World War II." What was she trying to do, from what you can tell? Why would it get that kind of a reaction?

The derivatives were a major source of revenues for a few big banks, and those who were making lots of money out of it obviously wanted to continue with the source of money.

You have to ask the question, did the economy really grow so poorly in the decades before we invented derivatives? Answer: We did actually pretty well. We did better in that quarter century after World War II before we had derivatives than we've done since then.

You have to ask the question, what are financial markets supposed to do? They're supposed to allocate capital; they're supposed to manage risk; they're supposed to do this all at low transaction costs.

In retrospect, we can see that our financial markets misallocated capital, mismanaged risk, created risk, and did it all at high transaction costs. It's very clear that they were involved in trying to maximize transaction costs. That's their revenues; that's their profits. Some of the innovations in risk management had the potential of enabling firms to undertake more risk than they otherwise would have by shifting the risk off to others, and that would have facilitated the growth of the real sector of our economy.

On the other hand, these derivatives are instruments for gambling: non-transparent, difficult to see what's going on. And in that case, they are increasing risk, diverting attention from the real functions of the financial markets and leading to poor performance of the economy.

Without regulation, you're going to wind up with the negative aspects of derivatives and not the positive aspects. And that's precisely what happened. So while they were a potential instrument for improving financial markets, if they are not used correctly, they are a potential -- as somebody said -- weapon of mass financial destruction. And that's what they turned out to be.

The lack of transparency illustrated by AIG [American International Group] and what happened there -- we should understand that magnitude of the problem. When I was in the Clinton administration, we debated long hours over welfare reform, over dealing with some of our toxic-waste problems. There were so many things that we wanted to do but we couldn't do because we didn't have the money. The amounts of money that we were talking about were a few billions of dollars. President Bush vetoed the bill to provide health insurance for poor Americans, saying we couldn't afford it. Again, talking about a few billions of dollars. And that was just a few months before we found $700 billion to bail out our banks. And of that, almost $200 billion went to AIG.

So we have to bear in mind when we're saying that these banks made a mistake, they made mistakes that cost us so much money that would have allowed us to do so many other things. We're not talking about nickel-and-diming; we're talking about big dollars. These are not minor little mistakes; these are big, big mistakes. ...

Let me give you another example of the lack of transparency, so not transparent that the financial institutions themselves didn't know what was going on. And if they didn't know what was going on, how can ordinary investors know what's going on? How can the regulators know what's going on? How can we have a well-functioning financial system?

The financial institutions that were creating these derivatives, these gambles, they would bet this bank would go down. "I'll bet you so much, a couple billion dollars." And then they would change their mind and say, "No, no, let's cancel that bet." But rather than cancel the bet, the other party would make a bet going the other direction. So if I bet you $10 and you bet me $10, the net is zero. So that's how you got these gross numbers that were in the trillions. They said, "Don't worry; these net out." That's true, except if one thing happens: if one of the two parties goes bankrupt. If A owes B and B owes A, but A goes bankrupt, then A doesn't owe B, but B still owes A. They don't net out.

If you ask them, they would have said: "Who could believe that any of them would go bankrupt? These are the biggest companies in the world -- AIG, the biggest insurance company in the world." But then you ask, what were they betting? They were betting on the demise of each of these companies. That's what the market was. So they at the same time said it would never happen, and yet the market was bets about that it did happen. Total schizophrenia. ...

So they created a system that was so non-transparent that each of the banks didn't really know their own balance sheets. What they knew is they didn't know, and they knew that they couldn't know what a balance sheet of any other firm was.

Financial markets are based on trust. That trust evaporated, and our financial markets came to a collapse. And that is part of what has led to the economic crisis, the freefall from which we are now just recovering.

[So why was the CFTC prevented from regulating?]

I think there are two or three aspects of this. The first is obviously this ideology of free market economics -- don't interfere -- and that's a presumption.

That's Greenspan?

That's Greenspan, and it's a lot of other people as well.

The second is very simple: the special interests. Lobbyists, campaign contributions, they were making money, and they want to continue making money. It was generating fees. Interesting thing is that right now, one of the big debates is to what extent should these derivatives be traded on exchanges or over the counter. To what extent should they be standardized products rather than tailor-made? The fact is when they're traded on exchanges and are standardized products, there is strong competition and a lot of transparency. Competition and transparency drives profits down, drives down transaction costs. The banks don't want that because they make their money from transaction costs, and they like lots of non-transparency. So that's what the battle is right now. ...

But the third point is financial markets have consistently tried to use fear to motivate, to get the rest of us to do what they want. ... It was fear that led to the hundreds of billions of dollars that were turned over to the financial markets in response to the crisis. And that was exactly the same tactic that they tried to use in the late '90s. They said, "If you do this, the whole thing will collapse."

They used to say when I was in the Council of Economic Advisers, if you talk about the appropriate strategy for monetary policy, it will lead to turmoil in the markets, and the whole economy will collapse -- you know, fear, over and over again. Greenspan said, "If you don't cut the deficit, the whole economy will collapse." And yet a few years later, Greenspan supported the tax cuts that led to the soaring deficits. So they used fear as an instrument to get what they want. And unfortunately, people say these are the wizards of finance, and they give deference to these so-called wizards of finance. But they shouldn't.

Was Rubin especially susceptible and vulnerable to that argument? Was he a handmaiden, or was he a willing participant, even leader, in that movement?

This use of fear as a tactic I heard from almost all of the major participants in the market -- from Rubin, from Greenspan, from Summers. I can't tell whether they really believed it or whether they found it a convenient argument. I don't know whether they really didn't understand economics, didn't have faith in the market.

I mean, that's the strange thing, because if you think that the markets are really understanding of what's going on, they would be able to see through discussion. ... I actually had more confidence in the market than many of these market participants because I said, "Look, they're going to be able to make judgments about which of these statements make sense and which don't."

... Should Born have known what was inevitably going to happen to her and her ideas?

I think that she was fulfilling her responsibility. When you take on these jobs, if you do it in a responsible way, you say the reason there's regulation is to prevent these kinds of abuses. And she believed that the force of argument would win. Maybe that was a little bit naive, but after all, we had just had this approach to a global financial crisis, at least in the eyes of many, with the Long-Term Capital Management collapse. So you would have thought that this coming so close to a global financial crisis would say: "We have to do something about this. We can't just let things go on as they did before." ...

But instead what happened was Congress passed a moratorium that said her agency can never regulate. And by 2000, it passed the CFMA [Commodity Futures Modernization Act], which essentially says we're going to deregulate the world of derivatives. And it passed the repeal of Glass-Steagall, the Gramm-Leach-Bliley. So in response to LTCM and in response to her impulse, in fact, we go completely the other way.

It's actually even more striking, because economic theory had explained why it was that we need an important role of regulation. We had had a global financial crisis in '97, '98 where we saw the dangers that capital-market liberalization had brought upon the world. ...

... Where was our government at that moment?

Government inevitably is going to reflect the pressure of special interests, particularly as elections get near. And remember, many of these people came from or were closely allied with financial markets. We have a problem of revolving doors: people coming from the financial markets, going to government and going back to financial markets. Their mind-set is affected by financial markets; they see things through the lens of the financial markets. And so they don't have to be influenced; they are the financial markets, in a sense. ... If we had had more people that, for instance, had suffered from the problems of predatory lending, there might have been less confidence that financial markets always work so well. ...

In the fall, after the meltdown, Alan Greenspan goes before the Congress, and he does a sort of mea culpa. What did you make of that?

I think it was a moment of honesty. I think he had genuinely believed in self-regulation, which I view as an oxymoron. Now, as an economist, we realized that the whole notion of self-regulation was an absurdity, because one of the reasons for regulation is what we call externalities. A failure in a bank or a failure of the financial system has an effect on everybody. And the bank is looking only at its direct cost and benefits, not on the cost on the rest of our society. And it's those external effects that provide the motivation for government regulation. ...

He didn't admit to that problem, but what he did admit to is he thought that at least the bankers would have enough rationality that they would look after their self-interest; that they would not engage in excessive risk taking to the point that they would put their shareholders and bondholders in jeopardy. But to me, if you look at the incentive structures that were confronting the managers of these banks, they had incentive structures that encouraged excessive risk taking and shortsighted behavior. ...

Do you think it was hard for Greenspan to say that?

Yes, I do, because it was so much part of his mind-set and his conviction. I think Greenspan was honestly doing what he thought was best for the economy for a long period of time. He was a public servant, and we should never forget that. For 18 years, he worked very hard, night and day, for what he thought was in the interest of the American people. And he did this, I think, with a particular mind-set and talking to a particular group of people that helped shape that mind-set with a particular set of beliefs. He could have gotten a lot more money if he had been in the private sector. So he really did sacrifice a great deal to pursue what he thought was in the public interest. ...

If Born would have succeeded, would things actually have been different? ...

I think to understand the crisis of 2007, 2008, 2009, you have to understand that it had many, many sources, many, many factors that contributed to it. The underlying recklessness of the banks, their perverse incentive structures, the fact that they were too big to fail encouraged them to engage in excessive risk taking; meant that if you had tied their hand in one direction, it's likely that they would have moved in another direction.

But it's absolutely clear to me that if we had restricted the derivatives, some of the major problems would have been avoided. Some of what it has cost American taxpayers -- a great deal would have been avoided. I think there is a very high probability, for instance, that we would not have had to pay out the hundreds of billions of dollars that have gone to AIG, that much of the other financial turmoil we would have avoided. But we still would have had the problems of the mortgages; we still would have had the problems at rating agencies.

So I think it's too simplistic to say that if we had done this one thing, we would have avoided the crisis. ... I view her experience as a dramatic illustration of what was wrong with the system and the power of the financial markets to resist doing what should have been done. But they did it with predatory lending; they did it with mortgages; they did it in area after area. And it would have needed a comprehensive attack to stop that. ...

You write that once the credit crisis is behind us that we start charting a new direction, which is starting now. This is a dangerous moment. What do you mean by that?

The challenge we have right now is, are we going to create a financial system that actually does what a financial system is supposed to do? Provide credit to small- and medium-sized enterprise? Manage risk? Help homeowners manage the risk of owning their home? Provide capital to new enterprises, money to the venture capital firms? -- these basic core functions of the financial markets.

Our financial markets failed, and they failed massively. Take even one simple idea: electronic payment mechanism. Modern technology allows for us to have an efficient electronic payment mechanism. It shouldn't be the case that when you go to a store and you want to pay with a debit card that that merchant has to pay 1 percent or more to the bank. It should cost a couple of pennies.

The financial market would like to go back to the world as it existed before 2007 because they did very well. But our financial markets were too big. They were garnering over a third of all corporate profits. What should be a means became an end in itself. And, remarkably, it didn't even do what they were supposed to do.

So this is a dangerous moment, because if we don't get it right, we are likely to wind up with an even more politically influential financial system, banks that are even bigger, more too big to fail, too big to be financially resolved, and so the risk of another crisis some years down the line is going to be greater. The risk that our economy's performance will be weaker, the risk that there will be greater inequalities and a sense of injustice in our society will be higher.

So I think this is really a moment. I was very hopeful that in the aftermath of the crisis we could see what had gone wrong and say, "Let's fix it." But it may be that we are passing that critical moment. ...
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