Freefall: America, Free Markets, and the Sinking of the World Economy Paperback – October 4, 2010

This is an excellent book because it is very broad and comprehensive in its treatment of the recent 2007-2008 financial crisis but also because Stiglitz discusses the international consequences and the impact such a financial disaster should have on the field and study of economics. Stiglitz discusses the five primary underlying causes of the 2007-2008 financial crisis as bad lending practices, fees and incentives allowed mortgage originators and others to ignore the weaknesses of the underlying mortgages, the collateral was inflated in a housing bubble, the financial institutions were over-leveraged, and a wilderness of new derivatives gave the impression that risks were under control when in fact they had become unsustainable. Stiglitz does not look for villains or try to blame the crisis on moral or personal failures. Rather, he indicates and supports his contention that this was a systemic failure put into place by failure to correctly estimate the dangers of deregulation and to manage the incentive systems so that moral hazard was controlled rather than increased. Stiglitz is a structuralist who does not wallow in terms like ‘greed’ which is so evident in the popular press. In Stiglitz’s view, greed cannot be addressed but incentives and opportunities for greed can be. He takes a systemic structural view to how the crisis came about and how the crisis should be addressed. Stiglitz also is able to contextualize the crisis by pointing out data regarding how wages for the middle and lower-middle classes has stagnated since around 1981. More women entered the workforce which allowed families to maintain a stable standard of living but this required two wage earners for each household rather than one. As wages and standards of living stagnated for almost 25 years, home equity increased and equity withdrawals allowed middle income homes to maintain their standard of living.Stiglitz is an extremely well organized writer. For example he outlines the content of a good mortgage product: low interest rates, low transaction fees, predictable payments, no hidden costs, and protection against value loss or job loss. Stiglitz points out that financial markets should serve a societal good, like hospitals or schools or utility companies. Financial markets should optimally allocate under used capital for production and innovation while managing risks and maintaining low reasonable transaction fees. Stiglitz thinks these financial markets failed. There should be cause for concern around the financial health of the United States when in 2007 41% of all corporate profit was generated by financial firms. Support for innovations weakened in a market environment in which innovations that circumvented regulation and oversight gathered the focus of the financial industry.Stiglitz builds the case that efforts to blame the government for the 2007-2008 financial crises are insubstantial. Ironically the financial instruments used against the lower working classes eventually brought down the financial institutions themselves. Efforts to deregulate and weaken government oversight resulted in the United States owning the largest automobile and insurance companies in the world. Stiglitz points out those subsidies to financial corporations make the economic system less efficient and these subsidies when to financial firms which had gone to great lengths to avoid paying their fair share of taxes. Another irony pointed out by Stiglitz was that executive contracts at AIG were fully honored despite huge losses because the case was made that the government should not undermine contracts, whereas the union contracts at GM were undermined and had to be re-negotiated. One sentence from the book summarizes this: The 7 largest financial firms had losses of 100 billion dollars, were bailed out by the government with 175 billion dollars, and then gave the very executives that created the crisis 33 billion in bonuses.This book spends a reasonable amount of time on the financial crisis but then analyzes the recovery and stimulus strategies. Stiglitz points out that a crisis does not destroy the underlying assets of an economy- physical plants, natural resources, the knowledge and skills of the workforce, technical knowledge and technologies are all still there. He points out the necessary ingredients for a successful stimulus package which would include: fast action and implementation, use of the multiplier effect to spread the impact of the stimulus, address long term infrastructural problems, invest in the future through research and innovation, should be fair to the middle class working families not just the affluent, should provide relief for short term hardships and should target job loss. Stiglitz makes the case that the stimulus package after the 2007-2008 crisis was too small and only spread out the pain of a slow recovery. Stiglitz is also critical of the lack-luster efforts to restructure financial markets by stopping casino type risks in derivative markets that result in little if any larger societal good. Further, Stiglitz spends considerable effort to explain multiple strategies that could have been undertaken for homeowners other than foreclosures, none of which were pursued. There was a clear tendency to blame the financially illiterate lower middle classes for the crisis when responsibility lay with the financial industry infrastructure and its perverse incentives. Mortgage originators and banks engaged in poor risk assessments and predatory lending practices – yet most government rescue efforts went to those who perpetuated the crisis.Stiglitz points out that capitalism is an extremely robust economic model. It defeated feudalism during the middle ages. It can withstand high levels of inequality but eventually if private rewards are inverse to societal needs, then the entire system is in jeopardy.Stiglitz has studied the impact of unequal knowledge in market transactions and finds that imperfect and asymmetric information challenges the concept of transparent equitable market transactions. Therefore the interest of the consumer should be a government responsibility.Financial markets, in Stiglitz’s view, should benefit society as a whole by better allocation of capital to the most productive enterprise and to better manage risks. The financial crisis of 2007-2008 demonstrates that these markets failed. Their executives were rewarded with astronomical salaries and bonuses because they were supposed to know how to manage risks and they failed. Stiglitz points out that if these major financial firms were too big to fail, then they were too expensive to save and too big to manage. In fact, the failure of Lehman Brothers demonstrated these firms were unable to calculate their own worth. Lehman Brothers was showing 26 billion in assets on their books when in fact they had over 200 billion in losses.Stiglitz finds the argument that TARP was necessary to strengthen the firms that managed most of American’s pension funds. He points out those retired and retiring tax payers would benefit more if the TARP money had been used to strengthen Social Security.I found the book to be fascinating and far reaching with sections on how stock options for executives dilute share owner equity, the use of off-shore money havens that help support terrorist activities, and the Glass-Stegall act of 1933 that built a firewall between commercial and investment banking. Like Kaynes, Galbraith, and Krugman, Stiglitz does not think markets are self correcting. He points out that the irony of the Reagan-Thatcher approach to less government regulation led to more government control.

Even if one disagrees with Stiglitz's ideological biases, this exposition of recent economic events is excellent, both accurate and fair in its criticisms. Stiglitz also provides a good discussion of the trade imbalances that afflict the world economy, as globalization is his specialty. Best is the challenges he presents to his fellow economists. But it's not without its blemishes. Since I have given the book five stars I will skip over the kudos and address its weaknesses.Stiglitz sets up a weak strawman in market "fundamentalism," as most serious free market advocates eschew dogma and see a limited role for government, especially to insure open and competitive markets. Stiglitz himself admits the dominant role of markets and only argues for a subjective "balance" between govt regulation and markets. This continuum can be freely debated, as many of the recent market failures stemmed from circumventing free market principles. Most of the violations Stiglitz cites boil down to inside actors using political or economic power to secure "heads we win, tails you lose" outcomes. This is what happened across the banking system as we privatized the returns and socialized the risks with bailouts. A functioning market economy relies on trust and must prevent blatant violations of the rules of voluntary exchange. Thus the crisis was not a repudiation of free markets, it was both a failure of risk management and a warning regarding the abuse of market principles.The policy debate over govt regulation too often slips into the idea of the regulatory bureaucrat rather than the dynamics of self-regulation based upon competing interests. Our political democracy relies on competing interests and a governing structure for checks and balances, with minimal monitoring. Our market structures should strive to do the same with competitors policing each other. Stiglitz mostly steers clear of this distinction while conceding that much of the blame for the financial crisis was the agency problem that befell not only the private sector, but also the public sector. Regulatory "capture" is a serious concern for regulating the financial sector.Stiglitz correctly castigates the Bush and Obama administrations for laxness and ineptness in managing the crisis, but whitewashes the Clinton years, when much of the financial deregulation was enacted. The Clinton regime was instrumental to the Democratic courtship of Wall Street and Stiglitz himself was a prominent Clinton economic advisor. Obama has picked up where Clinton left off, reappointing many from his team. (Hope and change turned out to be more of the same.) For its part, Wall Street is an equal opportunity player in Washington.The most controversial issue is probably Stiglitz's unwavering support of Keynesian demand stimulus. There is reason to suspect this cure-all for a deflating economy, but Stiglitz dismisses all doubts. However, the effectiveness of demand stimulus depends on the Keynesian multiplier, which in turn depends on a healthy banking system extending credit in response to credit demand from the private sector. In the aftermath of a debt deflation, both of these conditions fail in robustness. With a balance sheet recession, it may well be that the Keynesian multiplier is closer to zero than the hoped for 1.5. Another way to look at this is that Keynesian policies may be appropriate AFTER a collapse in prices due to massive deleveraging but much less effective in PREVENTING that collapse. The Japanese experience suggests that propping up a zombie banking system can dangerously prolong the post-bust correction. In this context the Fed's policy of reflation is likely to yield more crippling asset bubbles.The most productive discussion is when Stiglitz turns on his fellow economists. His criticism of the dominant neoclassical paradigm is spot on, especially when it comes to macroeconomic theory. Our current macropolicies are so confused because our theoretical tools are less useful in a nonlinear world and this is especially true in the world of finance. Rational actor assumptions have limited value in a real world where people are loss averse, heterogeneous and adaptable in their preferences, and show a tendency to herd behavior. Our most intractable policy problems are those of skewed or maldistributions, whether they be income and wealth inequality, global warming, health care, hunger or energy. Mathematical models based on fixed preferences, simultaneous equations, and equilibrium conditions are not amenable to distributional dynamics. Thus, the solution to inequality always regresses back to initial conditions, like education or material endowments. Instead, our policies should be addressing the access and distribution of financial capital and the dynamics of our financial markets. The rich are getting richer off their leveraged capital and political influence, not their good looks or brains.Given that managing uncertainty may be the best we can do in public policy, Stiglitz correctly argues for the dominant role of risk management. But he also fails to consider how risk and uncertainty is most effectively managed through decentralization and diversification. This is accomplished through wide and deep markets. Social insurance pooling may be an important corollary to private risk management where private markets are incomplete, but is far less efficient and prone to unmanageable moral hazard costs. Think how many would choose to cash in their 401(k) or private pension for Social Security promises, or their private health insurance for Medicare? The bottom line is that health care and retirement funding are private goods and forcing them into the public goods model only hampers their production and distribution. We may need a safety net, but that's as much as the empirical data supports. Entitlement reform will require private substitutes and this makes it critical we insure that markets function as intended. This may be the best argument for financial market reform.I suppose one could write a book instead of a review, but Stiglitz has already written one that offers the reader much food for thought. I suggest not taking anything for granted, as Stiglitz has his own ideological agenda to hoe. But he does a very commendable job in debunking much of the partisan-motivated bloviating.

Riveting ideas about the way the US should have recovered. It's fascinating to read this book with hindsight and see how close Stiglitz's predictions were to actual outcomes.The book is understandable for all audiences but some of the economics jargon may come a bit thick and fast for people who have not previously studied the subject.Overall, a great read for budding economists and experts alike.

I read this at the time the great recession of 07 occurred and it certainly provided more than just an interesting read but a clearer perspective of what was occurring at the time.

This is a superbly written, easily read and decisive analysis of the crisis in the world economy by a very good economist.

well written and intriguing story,very enjoyable and well explained story, recommended.

Good