Joseph E. Stiglitz's Blog, page 14

Alternatives to austerity | Joseph Stiglitz

It's possible to cut the US deficit in a growth-friendly way that reduces inequality. But certain powerful groups won't like it

In the aftermath of the great recession, countries have been left with unprecedented peacetime deficits and increasing anxieties about their growing national debts. In many countries, this is leading to a new round of austerity – policies that will almost surely lead to weaker national and global economies and a marked slowdown in the pace of recovery. Those hoping for large deficit reductions will be sorely disappointed, as the economic slowdown will push down tax revenues and increase demands for unemployment insurance and other social benefits.

The attempt to restrain the growth of debt does serve to concentrate the mind – it forces countries to focus on priorities and assess values. The United States is unlikely in the short-term to embrace massive UK-style budget cuts. But the long-term prognosis – made especially dire by healthcare reform's inability to make much of a dent in rising medical costs – is sufficiently bleak that there is increasing bipartisan momentum to do something. President Barack Obama has appointed a bipartisan deficit-reduction commission, whose chairmen recently provided a glimpse of what their report might look like.

Technically, reducing a deficit is a straightforward matter: one must either cut expenditures or raise taxes. It is already clear, however, that the deficit-reduction agenda, at least in the US, goes further: it is an attempt to weaken social protections, reduce the progressivity of the tax system, and shrink the role and size of government – all while leaving established interests, such as the military-industrial complex, as little affected as possible.

In the US (and some other advanced industrial countries), any deficit-reduction agenda has to be set in the context of what happened over the last decade:

• A massive increase in defence expenditures, fuelled by two fruitless wars, but going well beyond that;

• Growth in inequality, with the top 1% garnering more than 20% of the country's income, accompanied by a weakening of the middle class – median US household income has fallen by more than 5% over the last decade, and was in decline even before the recession;

• Underinvestment in the public sector, including in infrastructure, evidenced so dramatically by the collapse of New Orleans's levies; and

• Growth in corporate welfare, from bank bailouts to ethanol subsidies to a continuation of agricultural subsidies, even when those subsidies have been ruled illegal by the World Trade Organisation.

As a result, it is relatively easy to formulate a deficit-reduction package that boosts efficiency, bolsters growth and reduces inequality. Five core ingredients are required.

First, spending on high-return public investments should be increased. Even if this widens the deficit in the short run, it will reduce the national debt in the long run. What business wouldn't jump at investment opportunities yielding returns in excess of 10% if it could borrow capital – as the US government can – for less than 3% interest?

Second, military expenditures must be cut – not just funding for the fruitless wars, but also for the weapons that don't work against enemies that don't exist. The US has continued as if the cold war never came to an end, spending nearly as much on defence as the rest of the world combined.

Following this is the need to eliminate corporate welfare. Even as America has stripped away its safety net for people, it has strengthened the safety net for firms, evidenced so clearly in the great recession with the bailouts of AIG, Goldman Sachs, and other banks. Corporate welfare accounts for nearly 50% of total income in some parts of US agro-business, with billions of dollars in cotton subsidies, for example, going to a few rich farmers, while lowering prices and increasing poverty among competitors in the developing world.

An especially egregious form of corporate special treatment is that afforded to the drug companies. Even though the US government is the largest buyer of their products, it is not allowed to negotiate prices, thereby fuelling an estimated increase in corporate revenues – and costs to the government – approaching $1tn dollars over a decade.

Another example is the smorgasbord of special benefits provided to the energy sector, especially oil and gas, thereby simultaneously robbing the treasury, distorting resource allocation and destroying the environment. Then there are the seemingly endless giveaways of national resources – from the free spectrum provided to broadcasters to the low royalties levied on mining companies to the subsidies to lumber companies.

Creating a fairer and more efficient tax system, by eliminating the special treatment of capital gains and dividends, is also needed. Why should those who work for a living be subject to higher tax rates than those who reap their livelihood from speculation (often at the expense of others)?

Finally, with more than 20% of all income going to the top 1%, a slight increase, say 5%, in taxes actually paid would bring in more than $1tn over the course of a decade.

A deficit-reduction package crafted along these lines would more than meet even the most ardent deficit hawk's demands. It would increase efficiency, promote growth, improve the environment and benefit workers and the middle class.

There's only one problem: it wouldn't benefit those at the top, or the corporate and other special interests that have come to dominate America's policymaking. Its compelling logic is precisely why there is little chance that such a reasonable proposal would ever be adopted.

• Copyright: Project Syndicate 2010.

• A podcast of this commentary is also available.

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Foreclosures and banks' debt to society | Joseph Stiglitz

Rewritten bankruptcy provisions reduce indebted homeowners to servitude. What has become of the rule of law in the US?

The mortgage debacle in the United States has raised deep questions about "the rule of law", the universally accepted hallmark of an advanced, civilised society. The rule of law is supposed to protect the weak against the strong, and ensure that everyone is treated fairly. In America, in the wake of the subprime mortgage crisis, it has done neither.

Part of the rule of law is security of property rights – if you owe money on your house, for example, the bank can't simply take it away without following the prescribed legal process. But in recent weeks and months, Americans have seen several instances in which individuals have been dispossessed of their houses even when they have no debts.

To some banks, this is just collateral damage: millions of Americans – in addition to the estimated 4 million in 2008 and 2009 – still have to be thrown out of their homes. Indeed, the pace of foreclosures would be set to increase – were it not for government intervention. The procedural shortcuts, incomplete documentation and rampant fraud that accompanied banks' rush to generate millions of bad loans during the housing bubble has, however, complicated the process of cleaning up the ensuing mess.

To many bankers, these are just details to be overlooked. Most people evicted from their homes have not been paying their mortgages, and, in most cases, those who are throwing them out have rightful claims. But Americans are not supposed to believe in justice on average. We don't say that most people imprisoned for life committed a crime worthy of that sentence. The US justice system demands more, and we have imposed procedural safeguards to meet these demands.

But banks want to shortcircuit these procedural safeguards. They should not be allowed to do so.

To some, all of this is reminiscent of what happened in Russia, where the rule of law – bankruptcy legislation, in particular – was used as a legal mechanism to replace one group of owners with another. Courts were bought, documents forged, and the process went smoothly. In America, the venality is at a higher level. It is not particular judges that are bought, but the laws themselves, through campaign contributions and lobbying, in what has come to be called "corruption, American-style".

It was widely known that banks and mortgage companies were engaged in predatory lending practices, taking advantage of the least educated and most financially uninformed to make loans that maximised fees and imposed enormous risks on the borrowers. (To be fair, the banks tried to take advantage of the more financially sophisticated as well, as with securities created by Goldman Sachs that were designed to fail.) But banks used all their political muscle to stop states from enacting laws to curtail predatory lending.

When it became clear that people could not pay back what was owed, the rules of the game changed. Bankruptcy laws were amended to introduce a system of "partial indentured servitude". An individual with, say, debts equal to 100% of his income could be forced to hand over to the bank 25% of his gross, pre-tax income for the rest of his life, because the bank could add on, say, 30% interest each year to what a person owed. In the end, a mortgage holder would owe far more than the bank ever received, even though the debtor had worked, in effect, one-quarter time for the bank.

When this new bankruptcy law was passed, no one complained that it interfered with the sanctity of contracts: at the time borrowers incurred their debt, a more humane – and economically rational – bankruptcy law gave them a chance for a fresh start if the burden of debt repayment became too onerous.

That knowledge should have given lenders incentives to make loans only to those who could repay. But lenders perhaps knew that, with the Republicans in control of government, they could make bad loans and then change the law to ensure that they could squeeze the poor.

With one out of four mortgages in the US under water – more owed than the house is worth – there is a growing consensus that the only way to deal with the mess is to write down the value of the principal (what is owed). America has a special procedure for corporate bankruptcy, called Chapter 11, which allows a speedy restructuring by writing down debt, and converting some of it to equity.

It is important to keep enterprises alive as going concerns, in order to preserve jobs and growth. But it is also important to keep families and communities intact. So, America needs a "homeowners' Chapter 11".

Lenders complain that such a law would violate their property rights. But almost all changes in laws and regulations benefit some at the expense of others. When the 2005 bankruptcy law was passed, lenders were the beneficiaries; they didn't worry about how the law affected the rights of debtors.

Growing inequality, combined with a flawed system of campaign finance, risks turning America's legal system into a travesty of justice. Some may still call it the "rule of law", but it would not be a rule of law that protects the weak against the powerful. Rather, it would enable the powerful to exploit the weak.

In today's America, the proud claim of "justice for all" is being replaced by the more modest claim of "justice for those who can afford it". And the number of people who can afford it is rapidly diminishing.

Copyright: Project Syndicate, 2010

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A currency war has no winners | Joseph Stiglitz

For the global economy to revive, countries need to co-operate rather than devalue their currencies

It's easy to see why some policymakers hope favourable exchange rates could put America's economy back on track. Amid growing fears of a Japanese-style malaise, the other options are either off the table or likely to be ineffective. Political gridlock and soaring debt have stymied an effective second stimulus, and monetary policy has not reignited investment. But weakening the dollar to boost exports is a risky strategy – it could result in exchange rate volatility and protectionism; worse, it invites a response from competitors. In this fragile global economic environment, a currency war will make everybody a loser.

Fortunately, there's an alternative. Global co-operation based on growth-enhancing policies of structural reform, economic stimulus and long-term institutional changes in the global monetary system would be far more effective.

We know the dangers of devaluation because we've been here before. In the 1930s, beggar-thy-neighbour policies prolonged the Great Depression. In more normal times, the US might be able to make other currencies appreciate against the dollar – and help make US exports cheaper – by maintaining low interest rates and letting loose a flood of liquidity. But others, notably China, have signalled they won't play along.

The US must consider another path. History should be instructive. Forty years ago unilateral action by the US led to the breakdown of the Bretton Woods system, and the shift to the floating rate regime. Since then the global economy has been marked by unprecedented crises. Now the world is on the verge of moving to another regime of managed exchange rates and fragmented capital markets. This is not the result of extensive deliberations over what system would best serve all. Rather, it is the result of some countries taking actions they believe are in their own interest, without regard to others who do what they must to protect themselves.

US monetary policy was largely responsible for Latin America's lost decade, as the unprecedented increase in interest rates brought on the debt crisis of the early 1980s. So too, US monetary policy was largely responsible for the bubble whose breaking led to the global recession.

Now, the US is again engaged in behaviour that risks putting global stability in jeopardy. The irony is that the US is gaining little from the flood of liquidity. Low interest rates didn't spark investment in plant and equipment in the recession of 2001, and aren't likely to now. But the policies are having effects in other countries, as the cheap money looks around the world for the best prospects, and finds them in the emerging markets. We know the havoc that can follow as this money flows in and out. Large and abrupt changes in exchange rates can have devastating effects, especially in developing countries, as firms are forced into bankruptcy. The developing countries have been the engine of global growth, and such changes could destroy any hope of a quick global recovery.

While the costs to the world of competitive devaluations are clear, the benefits may be illusory. China is right to claim that adjusting its exchange rate will do little to correct America's multilateral trade deficit – the US will simply import apparel and textiles from other developing countries. Indeed, in the short run its trade deficit might worsen, even if other countries also adjusted their exchange rates, because the US would have to pay more (in dollars) for what it does import.

Currently each country pursues its own interests. The US worries about unemployment. China worries that a large appreciation of its currency will cause economic disorder there – unless global growth resumes. If we continue on this course, the emerging economies threatened with an onslaught of capital will protect themselves, through taxes, capital controls, regulations, and direct interventions – as they have been increasingly doing. As more countries resort to interventions to mitigate the consequences of unbridled monetary expansion -- in the US and perhaps in other advanced industrial countries -- those that try to retain faith in market-determined exchange rates will feel increasing pressure. In the end, the notion of market-determined exchange rates will seem as archaic as Bretton Woods. The result will be an increasingly fragmented global financial market, with almost inevitable spillovers into protectionism.

The answer to this seeming stalemate is simple: resume global growth, and appreciation of the currency will naturally follow. Restoring growth requires that all governments that have the capacity to expand aggregate demand do so. The US has a special responsibility, both because of its culpability in creating the global crisis and because it can borrow at low interest rates, an advantage partly derived from its status as the de facto reserve currency. This is the time for the US to make the high productivity investments it needs. Spending on things such as high speed rail and green technology would actually improve America's balance sheet. Higher growth would generate more tax revenue and lead to a lower long-run national debt. Such actions would not only help the US, but also have strong positive spillovers both in the short run (from the increased growth) and in the long run (from the technological improvements) for the rest of the world.

Both the US and China need structural changes, not just a realignment of exchange rates. Even in the short run, there is much they could do to contribute to global aggregate demand: increase wages, for example. In both countries, median household income has not kept up with growth. (Today, US median income is lower than it was in 1997!) Both need investments to adapt to global warming. Both need increased public spending on education and health for the poor. Both have to find better ways of allocating capital. America's financial markets demonstrated a remarkable inability to channel savings productively. China cannot continue to create excess capacity in manufacturing. China needs to find ways to recycle its massive savings, say to investments at home for urbanization, investments in developing countries with surplus labor and to help others meet the challenge of global warming.

This alternative rests on co-operation – mutual commitments to fiscal expansion, structural reforms and correcting trade imbalances by all countries (not just China). For some, exchange rate realignments will be a part of this; for others they may not. But each country will determine the best way of achieving agreed goals, with due attention to negative and positive externalities.

A new global reserve system or an expansion of IMF "money" (called special drawing rights, or SDRs) will be central to this co-operative approach. With such a system, poor countries would no longer need to put aside hundreds of billions of dollars to protect themselves from global volatility, and these would add to global aggregate demand.

It's true that, with such a system, the US would no longer enjoy the extraordinarily cheap borrowing that comes with being the minter of the most important global reserve currency. But the current arrangement is an anomaly. The world is at a critical juncture. The path it has embarked on today is marked by continued instability and anaemic growth. The co-operative path is better for all. It is, in fact, the only way that significant reductions in the global imbalances will be achieved and that the world will be restored to robust growth.

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To choose austerity is to bet it all on the confidence fairy | Joseph Stiglitz

The mystical belief is that a smaller deficit will lead to an investment boom. What Britain really needs now is another stimulus

The Keynesian policies in the aftermath of the Lehman brothers bankruptcy were a triumph of economic theory. In Europe, the US and Asia, the stimulus packages worked. Those countries that had the largest (relative to the size of their economy) and best-designed packages did best. China, for instance, maintained growth at a rate in excess of 8%, despite a massive decline in exports. In the US the stimulus was both too small and poorly designed – 40% of it went on household tax cuts, which were known not to provide much bang for the buck – and yet unemployment was reduced from what it otherwise would have been – over 12% – to 10%.

The stimulus was always thought of as a stopgap measure until the private sector could recover. In some countries, such as the US, politics rather than economics drove the size and design, with the result that they were too small and less effective than they might have been. Still, they worked. Now, financial markets – the same shortsighted markets that created the crisis – are focusing on soaring deficits and debts.

We should be clear. Most of the increase is not due to the stimulus but to the downturns and the bank bailouts. Those in the financial market are egging on politicians to ask whether we can afford another stimulus. I argue that Britain, and the world, cannot afford not to have another stimulus. We cannot afford austerity. In a better world, we might rightfully debate the size of the public sector. Even now there should be a debate about how government spends its money. But today cutbacks in spending will weaken Britain, and even worsen its long-term fiscal position relative to well-designed government spending.

There is a shortage of aggregate demand – the demand for goods and services that generates jobs. Cutbacks in government spending will mean lower output and higher unemployment, unless something else fills the gap. Monetary policy won't. Short-term interest rates can't go any lower, and quantitative easing is not likely to substantially reduce the long-term interest rates government pays – and is even less likely to lead to substantial increases either in consumption or investment. If only one country does it, it might hope to gain an advantage through the weakening of its currency; but if anything the US is more likely to succeed in weakening its currency against sterling through its aggressive quantitative easing, worsening Britain's trade position.

Of course if Britain succeeds in getting the world to believe that its economic policies are among the worst – an admittedly fierce contest at the moment – its currency may decline, but this is hardly the road to a recovery. Besides, in the malaise into which the global economy is sinking, the challenge will be to maintain exports; they can't be relied on as a substitute for domestic demand. The few instances where small countries managed to grow in the face of austerity were those where their trading partners were experiencing a boom.

Lower aggregate demand will mean lower tax revenues. But cutbacks in investments in education, technology and infrastructure will be even more costly in future. For they will spell lower growth – and lower revenues. Indeed, higher unemployment itself, especially if it is persistent, will result in a deterioration of skills, in effect the destruction of human capital, a phenomena which Europe experienced in the eighties and which is called hysteresis. Lower tax revenues now and in the future combined with lower growth imply a higher national debt, and an even higher debt-to-GDP ratio.

Matters may be even worse if consumers and investors realise this. Advocates of austerity believe that mystically, as the deficits come down, confidence in the economy will be restored and investment will boom. For 75 years there has been a contest between this theory and Keynesian theory, which argued that spending more now, especially on public investments (or tax cuts designed to encourage private investment) was more likely to restore growth, even though it increased the deficit.

The two prescriptions could not have been more different. Thanks to the IMF, multiple experiments have been conducted – for instance, in east Asia in 1997-98 and a little later in Argentina – and almost all come to the same conclusion: the Keynesian prescription works. Austerity converts downturns into recessions, recessions into depressions. The confidence fairy that the austerity advocates claim will appear never does, partly perhaps because the downturns mean that the deficit reductions are always smaller than was hoped.

Consumers and investors, knowing this and seeing the deteriorating competitive position, the depreciation of human capital and infrastructure, the country's worsening balance sheet, increasing social tensions, and recognising the inevitability of future tax increases to make up for losses as the economy stagnates, may even cut back on their consumption and investment, worsening the downward spiral.

No business with a potential for making investments yielding high returns would pass up the opportunity to make these investments if it could get access to capital at very low interest rates. But this is what austerity means for the UK.

Critics say government won't spend the money well. To be sure, there will be waste – though not on the scale that the private sector in the US and Europe wasted money in the years before 2008. But even if money is not spent perfectly, if experience of the past is a guide to the future, the returns on government investments in education, technology and infrastructure are far higher than the government's cost of capital. Besides, the choices facing the country are bleak. If the government doesn't spend this money there will be massive waste of resources as its capital and human resources are under-utilised.

Britain is embarking on a highly risky experiment. More likely than not, it will add one more data point to the well- established result that austerity in the midst of a downturn lowers GDP and increases unemployment, and excessive austerity can have long-lasting effects.

If Britain were wealthier, or if the prospects of success were greater, it might be a risk worth taking. But it is a gamble with almost no potential upside. Austerity is a gamble which Britain can ill afford.

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The wrong way for the Fed to go about regaining face | Joseph Stiglitz

Quantitative easing may seem an answer to the US's problems, but any benefits would likely be offset by the costs

With interest rates near zero, the US Federal Reserve and other central banks are struggling to remain relevant. The last arrow in their quiver is quantitative easing (QE), and it is likely to be almost as ineffective in reviving the US economy as anything else the Fed has tried in recent years. Worse, QE is likely to cost taxpayers a bundle, while impairing the Fed's effectiveness for years to come.

John Maynard Keynes argued that monetary policy was ineffective during the great depression. Central banks are better at restraining markets' irrational exuberance in a bubble – restricting the availability of credit or raising interest rates to rein in the economy – than at promoting investment in a recession. That is why good monetary policy aims to prevent bubbles from arising.

But the Fed, captured for more than two decades by market fundamentalists and Wall Street interests, not only failed to impose restraints, but acted as cheerleader. And, having played a central role in creating the current mess, it is now trying to regain face.

In 2001, lowering interest rates seemed to work, but not the way it was supposed to. Rather than spurring investment in plant and equipment, low interest rates inflated a real-estate bubble. This enabled a consumption binge, which meant debt was created without a corresponding asset, and encouraged excessive investment in real estate, resulting in excess capacity that will take years to eliminate.

The best that can be said for monetary policy over the past few years is that it prevented the direst outcomes that could have followed Lehman Brothers' collapse. But no one would claim that lowering short-term interest rates spurred investment. Indeed, business lending – particularly to small businesses – in both the US and Europe remains markedly below pre-crisis levels. The Fed and the European Central Bank have done nothing about this.

They still seem enamoured of the standard monetary-policy models, in which all central banks have to do to get the economy going is reduce interest rates. The standard models failed to predict the crisis, but bad ideas die a slow death. So, while bringing down short-term Treasury bill rates to near zero has failed, the hope is that bringing down longer-term interest rates will spur the economy. The chances of success are near zero.

Large firms are awash with cash, and lowering interest rates slightly won't make much difference to them. And lowering the rates that government pays has not translated into correspondingly lower interest rates for the many small firms struggling for financing.

More relevant is the availability of loans. With so many banks in the US fragile, lending is likely to remain constrained. Moreover, most small-business loans are collateral-based, but the value of the most common form of collateral, real estate, has plummeted.

The Obama administration's efforts to deal with the real estate market have been a dismal failure, perhaps succeeding only in postponing further declines. But even optimists don't believe that real estate prices will increase substantially any time soon. In short, QE – lowering long-term interest rates by buying long-term bonds and mortgages – won't do much to stimulate business directly.

It may help, though, in two ways. One way is as part of America's strategy of competitive devaluation. Officially, America still talks about the virtues of a strong dollar, but lowering interest rates weakens the exchange rate. Whether one views this as currency manipulation or as an accidental by-product of lower interest rates is irrelevant. The fact is that a weaker dollar resulting from lower interest rates gives the US a slight competitive advantage in trade.

Meanwhile, as investors look outside the US for higher yield, the flood of money out of the dollar has bid up exchange rates in emerging markets around the world. Emerging markets know this, and are upset – Brazil has vehemently expressed its concerns – not only about the increased value of their currency, but that the influx of money risks fuelling asset bubbles or triggering inflation.

The normal response of emerging-market central banks to bubbles or inflation would be to raise interest rates – thereby increasing their currencies' value still more. US policy is thus delivering a double whammy on competitive devaluation – weakening the dollar and forcing competitors to strengthen their currencies (though some are taking countermeasures, erecting barriers to short-term inflows and intervening more directly in foreign-exchange markets).

The second way QE might have a slight effect is by lowering mortgage rates, which would help to sustain real-estate prices. So QE would produce some – probably weak – balance-sheet effects.

But potentially significant costs offset these small benefits. The Fed has bought more than $1tn of mortgages, the value of which will fall when the economy recovers – which is precisely why no one in the private sector wants to buy them.

The government may pretend it has not experienced a capital loss, because, unlike banks, it is not required to use mark-to-market accounting. But no one should be fooled, even if the Fed holds the bonds to maturity. The attempt to ensure the losses are not recognised might tempt the Fed to rely excessively on untested, uncertain, and costly monetary-policy tools – such as paying high interest rates on reserves to induce banks not to lend.

It is good that the Fed is trying to make amends for its dismal pre-crisis performance. Regrettably, it is far from clear that it has changed its thinking and models, which failed to maintain the economy on an even keel before – and are certain to fail again. The Fed's previous mistakes proved extraordinarily costly. So will the new mistakes, even if the Fed strives to hide the price tag.

• Copyright Project Syndicate, 2010

• A podcast of this commentary is also available

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A better way to fix the US housing crisis | Joseph Stiglitz

Government policies to prop up the housing market not only have failed to fix the problem, they are prolonging the agony

A sure sign of a dysfunctional market economy is the persistence of unemployment. In the United States today, one out of six workers who would like a full-time job can't find one. It is an economy with huge unmet needs and yet vast idle resources.

The housing market is another US anomaly: there are hundreds of thousands of homeless people (more than 1.5 million Americans spent at least one night in a shelter in 2009), while hundreds of thousands of houses sit vacant.

Indeed, the foreclosure rate is increasing. Two million Americans lost their homes in 2008, and 2.8 million more in 2009, but the numbers are expected to be even higher in 2010. Financial markets performed dismally – well-performing, "rational" markets do not lend to people who cannot or will not repay – and yet those running these markets were rewarded as if they were financial geniuses.

None of this is news. What is news is the Obama administration's reluctant and belated recognition that its efforts to get the housing and mortgage markets working again have largely failed. Curiously, there is a growing consensus on both the left and the right that the government will have to continue propping up the housing market for the foreseeable future. This stance is perplexing and possibly dangerous.

It is perplexing because in conventional analyses of which activities should be in the public domain, running the national mortgage market is never mentioned. Mastering the specific information related to assessing creditworthiness and monitoring the performance of loans is precisely the kind of thing at which the private sector is supposed to excel.

It is, however, an understandable position: both US political parties supported policies that encouraged excessive investment in housing and excessive leverage, while free-market ideology dissuaded regulators from intervening to stop reckless lending. If the government were to walk away now, real-estate prices would fall even further, banks would come under even greater financial stress, and the economy's short-run prospects would become bleaker.

But that is precisely why a government-managed mortgage market is dangerous. Distorted interest rates, official guarantees and tax subsidies encourage continued investment in real estate, when what the economy needs is investment in, say, technology and clean energy.

Moreover, continuing investment in real estate makes it all the more difficult to wean the economy off its real-estate addiction, and the real-estate market off its addiction to government support. Supporting further real-estate investment would make the sector's value even more dependent on government policies, ensuring that future policymakers face greater political pressure from interest groups like real-estate developers and bonds holders.

Current US policy is befuddled, to say the least. The Federal Reserve Board is no longer the lender of last resort, but the lender of first resort. Credit risk in the mortgage market is being assumed by the government, and market risk by the Fed. No one should be surprised at what has now happened: the private market has essentially disappeared.

The government has announced that these measures, which work (if they do work) by lowering interest rates, are temporary. But that means that when intervention comes to an end, interest rates will rise – and any holder of mortgage-backed bonds would experience a capital loss – potentially a large one.

No private party would buy such an asset. By contrast, the Fed doesn't have to recognise the loss; while free-market advocates might talk about the virtues of market pricing and "price discovery", the Fed can pretend that nothing has happened.

With the government assuming credit risk, mortgages become as safe as government bonds of comparable maturity. Hence, the Fed's intervention in the housing market is really an intervention in the government bond market; the purported "switch" from buying mortgages to buying government bonds is of little significance. The Fed is engaged in the difficult task of trying to set not just the short-term interest rate, but longer-term rates as well.

Resuscitating the housing market is all the more difficult for two reasons. First, the banks that used to do conventional mortgage lending are in bad financial shape. Second, the securitisation model is badly broken and not likely to be replaced anytime soon. Unfortunately, neither the Obama administration nor the Fed seems willing to face these realities.

Securitisation – putting large numbers of mortgages together to be sold to pension funds and investors around the world – worked only because there were rating agencies that were trusted to ensure that mortgage loans were given to people who would repay them. Today, no one will or should trust the rating agencies, or the investment banks that purveyed flawed products (sometimes designing them to lose money).

In short, government policies to support the housing market not only have failed to fix the problem, but are prolonging the deleveraging process and creating the conditions for Japanese-style malaise. Avoiding this dismal "new normal" will be difficult, but there are alternative policies with far better prospects of returning the US and the global economy to prosperity.

Corporations have learned how to take bad news in stride, write down losses, and move on, but our governments have not. For one out of four US mortgages, the debt exceeds the home's value. Evictions merely create more homeless people and more vacant homes. What is needed is a quick write-down of the value of the mortgages. Banks will have to recognise the losses and, if necessary, find the additional capital to meet reserve requirements.

This, of course, will be painful for banks, but their pain will be nothing in comparison to the suffering they have inflicted on people throughout the rest of the global economy.

• Copyright: Project Syndicate, 2010

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Reform the euro or bin it | Joseph Stiglitz

The Greek crisis puts the currency's very survival at risk. Europe must now take long overdue action

The Greek financial crisis has put the very survival of the euro at stake. At the euro's creation, many worried about its long-term viability. When everything went well, these worries were forgotten. But the question of how adjustments would be made if part of the eurozone were hit by a strong adverse shock lingered. Fixing the exchange rate and delegating monetary policy to the European Central Bank eliminated two primary means by which national governments stimulate their economies to avoid recession. What could replace them?

The Nobel laureate Robert Mundell laid out the conditions under which a single currency could work. Europe didn't meet those conditions at the time; it still doesn't. The removal of legal barriers to the movement of workers created a single labour market, but linguistic and cultural differences make US-style labour mobility unachievable.

Moreover, Europe has no way of helping those countries facing severe problems. Consider Spain, which has an unemployment rate of 20% – and more than 40% among young people. It had a fiscal surplus before the crisis; after the crisis, its deficit increased to more than 11% of GDP. But, under EU rules, Spain must now cut its spending, which will likely exacerbate unemployment. As its economy slows, the improvement in its fiscal position may be minimal.

Some hoped the Greek tragedy would convince policymakers that the euro cannot succeed without greater co-operation (including fiscal assistance). But Germany (and its Constitutional Court), partly following popular opinion, opposed giving Greece the help that it needs.

To many, both in and outside of Greece, this stance was peculiar: billions had been spent saving big banks, but evidently saving a country of 11 million people was taboo. It was not even clear that the help Greece needed should be labelled a bailout: while the funds given to financial institutions like AIG were unlikely to be recouped, a loan to Greece at a reasonable interest rate would probably be repaid.

A series of half-offers and vague promises, intended to calm the market, failed. Just as the US had cobbled together assistance for Mexico 15 years ago by combining help from the International Monetary Fund and the G7, so too the EU put together an assistance programme with the IMF. The question was, what conditions would be imposed and how big would be the adverse impact?

For the EU's smaller countries, the lesson is clear: if they do not reduce their budget deficits there is a high risk of a speculative attack, with little hope for adequate assistance from their neighbours, at least not without painful and counterproductive pro-cyclical budgetary restraints. As European countries take these measures, their economies are likely to weaken – with unhappy consequences for the global recovery.

It may be useful to see the euro's problems from a global perspective. The US has complained about China's current account (trade) surpluses; but, as a percentage of GDP, Germany's surplus is even greater. Assume that the euro was set so that trade in the eurozone as a whole was roughly in balance. In that case, Germany's surplus means the rest of Europe is in deficit. And the fact that these countries are importing more than they are exporting contributes to their weak economies.

The US has been complaining about China's refusal to allow its exchange rate to appreciate relative to the dollar. But the euro system means Germany's exchange rate cannot increase relative to other eurozone members. If the exchange rate did increase, Germany would find it more difficult to export, and its economic model, based on strong exports, would face a challenge. At the same time, the rest of Europe would export more, GDP would increase, and unemployment would decrease.

Germany (like China) views its high savings and export prowess as virtues. But John Maynard Keynes pointed out that surpluses lead to weak global aggregate demand – countries running surpluses exert a "negative externality" on trading partners. Indeed, Keynes believed it was surplus countries, far more than those in deficit, that posed a threat to global prosperity; he went so far as to advocate a tax on surplus countries.

The social and economic consequences of the current arrangements should be unacceptable. Those countries whose deficits have soared as a result of the global recession should not be forced into a death spiral – as Argentina was a decade ago.

One proposed solution is for these countries to engineer the equivalent of a devaluation – a uniform decrease in wages. This, I believe, is unachievable, and its distributive consequences are unacceptable. The social tensions would be enormous. It is a fantasy.

There is a second solution: the exit of Germany from the eurozone or the division of the eurozone into two sub-regions. The euro was an interesting experiment, but, like the almost forgotten exchange rate mechanism that preceded it and fell apart when speculators attacked sterling in 1992, it lacks the institutional support required to make it work.

There is a third solution, which Europe may come to realise is the most promising for all: implement the institutional reforms, including the necessary fiscal framework, that should have been made when the euro was launched.

It is not too late for Europe to implement these reforms and thus live up to the ideals, based on solidarity, that underlay the euro's creation. But if Europe cannot do so, then perhaps it is better to admit failure and move on than to extract a high price in unemployment and human suffering in the name of a flawed economic model.

• Copyright: Project Syndicate

EuroGreeceGermanyEuropean UnionEconomicsInterest ratesEuropean Central BankIMFSpainJoseph Stiglitz
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A trade war with China isn't worth it | Joseph Stiglitz

Although a battle is ongoing over exchange rates, the US would be ill-advised to return to protectionist measures

The battle with the United States over China's exchange rate continues. When the recession began, many worried that protectionism would rear its ugly head. True, G20 leaders promised that they had learned the lessons of the Great Depression. But 17 of the G20's members introduced protectionist measures just months after the first summit in November 2008. The "buy America" provision in the United States' stimulus bill got the most attention. Still, protectionism was contained, partly due to the World Trade Organisation.

Continuing economic weakness in the advanced economies risks a new round of protectionism. In the US, for example, more than one in six workers who would like a full-time job can't find one.

These were among the risks associated with America's insufficient stimulus, which was designed to placate members of Congress as much as it was to revive the economy. With soaring deficits, a second stimulus appears unlikely, and, with monetary policy at its limits and inflation hawks being barely kept at bay, there is little hope of help from that department, either. So protectionism is taking pride of place.

The US treasury has been charged by Congress to assess whether China is a "currency manipulator". Although President Barack Obama has now delayed for some months when the treasury secretary, Timothy Geithner, must issue his report, the very concept of "currency manipulation" itself is flawed: all governments take actions that directly or indirectly affect the exchange rate. Reckless budget deficits can lead to a weak currency; so can low interest rates. Until the recent crisis in Greece, the US benefited from a weak dollar/euro exchange rate. Should Europeans have accused the US of "manipulating" the exchange rate to expand exports at its expense?

Although US politicians focus on the bilateral trade deficit with China – which is persistently large – what matters is the multilateral balance. When demands for China to adjust its exchange rate began during George Bush's administration, its multilateral trade surplus was small. More recently, however, China has been running a large multilateral surplus as well.

Saudi Arabia also has a bilateral and multilateral surplus: Americans want its oil and Saudis want fewer US products. Even in absolute value, Saudi Arabia's multilateral merchandise surplus of $212bn in 2008 dwarfs China's $175bn surplus. As a percentage of GDP, Saudi Arabia's current-account surplus, at 11.5% of GDP, is more than twice that of China. Saudi Arabia's surplus would be far higher were it not for US armaments exports.

In a global economy with deficient aggregate demand, current-account surpluses are a problem. But China's current-account surplus is actually less than the combined figure for Japan and Germany; as a percentage of GDP, it is 5%, compared with Germany's 5.2%.

Many factors other than exchange rates affect a country's trade balance. A key determinant is national savings. The US's multilateral trade deficit will not be significantly narrowed until it saves significantly more; while the recession induced higher household savings (which were near zero), this has been more than offset by the increased government deficits.

Adjustment in the exchange rate is likely simply to shift to where America buys its textiles and apparel – from Bangladesh or Sri Lanka, rather than China. Meanwhile, an increase in the exchange rate is likely to contribute to inequality in China, as its poor farmers face increasing competition from America's highly subsidised farms. This is the real trade distortion in the global economy – one in which millions of poor people in developing countries are hurt as America helps some of the world's richest farmers.

During the 1997-98 Asian financial crisis, the stability of China's renminbi played an important role in stabilising the region. So, too, the currency's stability has helped the region maintain strong growth, from which the world as a whole benefits.

Some argue that China needs to adjust its exchange rate to prevent inflation or bubbles. Inflation remains contained, but, more to the point, China's government has an arsenal of other weapons (from taxes on capital inflows and capital-gains taxes to a variety of monetary instruments) at its disposal.

But exchange rates do affect the pattern of growth, and it is in China's own interest to restructure and move away from high dependence on export-led growth. China recognises that its currency needs to appreciate over the long run, and politicising the speed at which it does so has been counterproductive. (Since it began revaluing its exchange rate in July 2005, the adjustment has been half or more of what most experts think is required.) Moreover, starting a bilateral confrontation is unwise.

Since China's multilateral surplus is the economic issue and many countries are concerned about it, the US should seek a multilateral, rules-based solution. Imposing unilateral duties after unilaterally labelling China a "currency manipulator" would undermine the multilateral system, with little pay-off. China might respond by imposing duties on those American products effectively directly or indirectly subsidised by America's massive bailouts of its banks and car companies.

No one wins from a trade war. So America should be wary of igniting one in the midst of an uncertain global recovery – as popular as it might be with politicians whose constituents are justly concerned about high unemployment, and as easy as it is to look for blame elsewhere. Unfortunately, this global crisis was made in America, and America must look inward, not only to revive its economy, but also to prevent a recurrence.

Copyright: Project Syndicate, 2010

US economic growth and recessionEconomicsCurrenciesChinaUS foreign policyUS politicsJoseph Stiglitz
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Dangers of deficit-cut fetishism | Joseph Stiglitz

Reducing government spending, especially in harder-hit economies like the UK, is a risk not worth taking at this point

A wave of fiscal austerity is rushing over Europe and America. The magnitude of budget deficits – like the magnitude of the downturn – has taken many by surprise. But despite protests by yesterday's proponents of deregulation, who would like the government to remain passive, most economists believe that government spending has made a difference, helping to avert another Great Depression.

Most economists also agree that it is a mistake to look at only one side of a balance sheet (whether for the public or private sector). One has to look not only at what a country or firm owes, but also at its assets. This should help answer those financial sector hawks who are raising alarms about government spending. After all, even deficit hawks acknowledge that we should be focusing not on today's deficit, but on the long-term national debt. Spending, especially on investments in education, technology, and infrastructure, can actually lead to lower long-term deficits. Banks' short-sightedness helped create the crisis; we cannot let government short-sightedness – prodded by the financial sector – prolong it.

Faster growth and returns on public investment yield higher tax revenues, and a 5 to 6% return is more than enough to offset temporary increases in the national debt. A social cost-benefit analysis (taking into account impacts other than on the budget) makes such expenditures, even when debt-financed, even more attractive.

Finally, most economists agree that, apart from these considerations, the appropriate size of a deficit depends in part on the state of the economy. A weaker economy calls for a larger deficit, and the appropriate size of the deficit in the face of a recession depends on the precise circumstances.

It is here that economists disagree. Forecasting is always difficult, but especially so in troubled times. What has happened is (fortunately) not an everyday occurrence; it would be foolish to look at past recoveries to predict this one.

In America, for instance, bad debt and foreclosures are at levels not seen for three-quarters of a century; the decline in credit in 2009 was the largest since 1942. Comparisons to the Great Depression are also deceptive, because the economy today is so different in so many ways. And nearly all so-called experts have proven highly fallible – witness the United States Federal Reserve's dismal forecasting record before the crisis.

Yet, even with large deficits, economic growth in the US and Europe is anemic, and forecasts of private-sector growth suggest that in the absence of continued government support, there is risk of continued stagnation – of growth too weak to return unemployment to normal levels anytime soon.

The risks are asymmetric: if these forecasts are wrong, and there is a more robust recovery, then, of course, expenditures can be cut back and/or taxes increased. But if these forecasts are right, then a premature "exit" from deficit spending risks pushing the economy back into recession. This is one of the lessons we should have learned from America's experience in the Great Depression; it is also one of the lessons to emerge from Japan's experience in the late 1990s.

These points are particularly germane for the hardest hit economies. The United Kingdom, for example, has had a harder time than other countries for an obvious reason: it had a real-estate bubble (though of less consequence than in Spain), and finance, which was at the epicenter of the crisis, played a more important role in its economy than it does in other countries.

The UK's weaker performance is not the result of worse policies; indeed, compared to the US, its bank bailouts and labor-market policies were, in many ways, far better. It avoided the massive waste of human resources associated with high unemployment in America, where almost one out of five people who would like a full-time job cannot find one.

As the global economy returns to growth, governments should, of course, have plans on the drawing board to raise taxes and cut expenditures. The right balance will inevitably be a subject of dispute. Principles like "it is better to tax bad things than good things" might suggest imposing environmental taxes.

The financial sector has imposed huge externalities on the rest of society. America's financial industry polluted the world with toxic mortgages, and, in line with the well established "polluter pays" principle, taxes should be imposed on it. Besides, well-designed taxes on the financial sector might help alleviate problems caused by excessive leverage and banks that are too big to fail. Taxes on speculative activity might encourage banks to focus greater attention on performing their key societal role of providing credit.

Over the longer term, most economists agree that governments, especially in advanced industrial countries with ageing populations, should be concerned about the sustainability of their policies. But we must be wary of deficit fetishism. Deficits to finance wars or give-aways to the financial sector (as happened on a massive scale in the US) lead to liabilities without corresponding assets, imposing a burden on future generations. But high-return public investments that more than pay for themselves can actually improve the well-being of future generations, and it would be doubly foolish to burden them with debts from unproductive spending and then cut back on productive investments.

These are questions for a later day – at least in many countries, prospects of a robust recovery are, at best, a year or two away. For now, the economics is clear: reducing government spending is a risk not worth taking.

Copyright: Project Syndicate, 2010.

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Economic growth (GDP)US economic growth and recessionEconomic policyEconomicsFinancial crisisTax and spendingJoseph Stiglitz
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