Stiglitz on the causes of the financial crisis and how to prevent the next one

Nobel laureate Joseph Stiglitz succinctly addresses the causes of the financial crisis and makes recommendations for preventing a recurrence here. He does not propose solutions to the current mess. 

Stiglitz says the Fed created a "flood of liquidity" and failed in its duty to impose and enforce prudential regulations on those involved in mortgage lending. This led to excessive leverage and a "pyramid scheme." The so-called "innovations" implemented by the financial industry were essentially just obfuscation of leverage and risk (as I had written here). He follows with additional criticisms of the financial industry and recommends 6 reforms:

1. Realign incentives in executive compensation systems at financial institutions.

2. Create a "financial product safety commission."

3. Create a "financial systems stability commission."

4. Impose other "speed bump" regulations to prevent too-rapid growth of borrowing.

5. Adopt better consumer lending laws, including laws that prevent predatory lending.

6. Enact better competition laws.

Thanks to Christine for the heads up.

Comments

[Christine]

So Roger, what would be wrong with reenacting the Glass-Steagall laws that kept us out of this kind of mess until Bill Clinton (!) wiped them out? Were they deficient?

Your piece on Obama's advisors is depressing.

[Skeptic]

Christine,

I think repeal of the remnants of Glass-Steagall reflected a mindset that financial institutions had become so sophisticated that they didn't need regulation. The idea was that the "discipline of the marketplace" is the only control necessary to keep the financial system working like a well oiled machine. The phrase "self regulation" was in common use.

But I don't think re-enacting G-S is likely to be a very good solution going forward. The basic G-S approach was to separate commercial banking from "investment banking." The commercial banking would be tightly regulated as to reserve requirements, maximum interest rates payable, government audits, lending standards, maximum terms of loans, etc. This was to keep commercial banking--the backbone of the real economy--functional, conservative, failsafe, and responsive to the Fed's power to regulate the money supply. Investment banking was a separate, very lightly regulated realm for those who understood they were taking big risks. In theory, a Lehman could go bankrupt without making waves on the commercial banking pond.

Now, money is created in so many other ways. When banks only originate loans and get them completely off their books in securitized packages, the reserve requirement does not effectively restrict the volume of loans they can generate. Now that we have abrogated Bretton-Woods (which required national governments to settle accounts by transferring gold), reserves and lending power are created just by running a current account deficit in international transactions. Etc. The regulatory system we need to deal with today's realities is probably very different from the regulations of the 1930s, but I have no idea what it should look like.