Tuesday, August 29, 2023

Review of Freefall: America, Free Markets, and the Sinking of the World Economy by Joseph E. Stiglitz

This book review was written by Eugene Kernes   

Book can be found in: 
Intriguing Connections = 1) What Goes Into An Economic Crisis?

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“There was little or no effective “quality control.”  Again, in theory, markets are supposed to provide this discipline.  Firms that produce excessively risky products would lose their reputation.  Share prices would fall.  But in today’s dynamic world, this market discipline broke down.  The financial wizards invented highly risky products that gave normal returns for a while – with the downside not apparent for years.  Thousands of money managers boasted that they could “beat the market,” and there was a ready population of shortsighted investors who believed them.  But the financial wizards go carried away in the euphoria – they deceived themselves as well as those who bought their products.  This helps explain why, when the market crashed, they were left holding billions of dollars’ worth of toxic products.” – Joseph E. Stiglitz, Chapter 1: The Making Of A Crisis, Pages 13-14

“Moral authority might even be put into doubt, given that the bailouts appeared bent on rewarding the very parties that had brought America and the world to the edge of ruin.  The public outrage at the financial sector, which had used its outsize profits to buy the political influence that first freed financial markets from regulations and then secured a trillion-dollar bailout, would likely only grow.  It was not clear how long the public would tolerate the hypocrisy of these long-time advocates of fiscal responsibility and free markets continuing to argue against help for poor homeowners on the grounds of moral hazard – that helping them out now would simply lead to more bailouts in the future and reduce incentives to repay loans – at the same time that they made unbridled requests of money for themselves.” – Joseph E. Stiglitz, Chapter 2: Freefall And Its Aftermath, Pages 39-40

“The entire series of efforts to rescue the banking system were so flawed, partly because those who were somewhat responsible for the mess – as advocates of deregulation, as failed regulators, or as investment bankers – were put in charge of the repair.  Perhaps not surprisingly, they all employed the same logic that had gotten the financial sector into trouble to get it out of it.  The financial sector had engaged in highly leveraged, non-transparent transactions, many off balance sheet; it had believed that one could create value by moving assets around and repackaging them.  The approach to getting the country out of the mess was based on the same “principles.”  Toxic assets were shifted from banks to the government – but that didn’t make them any less toxic.” – Joseph E. Stiglitz, Chapter 5: The Great American Robbery, Page 144


Is This An Overview?

The financial industry is meant to manage risk, allocate capital, and mobilize savings, all while keeping transaction costs low.  But the financial crisis in 2007 showed that the financial industry failed their function.  They mismanaged risk, misallocated capital, and indebted people, all while imposing high transaction costs.  The crisis was made by the financial industry, something that was done to the financial industry and everyone. 

Financial markets focused on maximizing returns, no matter the risks involved for the borrower.  Mortgage companies generated many inappropriate mortgages, and gave them to people who did not understand their effects with the assumption that housing prices would keep rising.  The mortgages were repackaged into financial instruments by banks, which made the securities products more complex.  An attempt to reduce the risk, but in practice just shifted the risk.  The rating agencies did not check the risk of the securities, but still gave the securities approval as the rating agencies were paid when they provided favorable ratings.

The financial industry analysts deceived themselves and their clients about the worthiness of the products.  Having purchased many of the toxic assets themselves.  When the crisis occurred, banks did not know the value of their own assets, nor those of other institutions.  Therefore, could not lend.  The government bailed out the banks, but that did not stop the banks from blaming the government.  The Federal Reserve has historically been willing to bailout banks, which created moral hazard as the banks took greater risks with a high expectation of being bailed out again.  While banks were being bailed out, banks used the money to pay dividends and bonuses, while denying government assistance to the rest of society because it would have created moral hazard.  In effect, the government had rewarded the people responsible for the financial crisis rather than seek accountability. 


What Did The Financial Industry Do? 

Securitization process repackaged mortgages and bundled them.  The innovative financial products were designed to shift risk from banks, while generating fees.  They were designed to avoid accounting and regulatory restraints.

The financial sector used their profits to buy political influence, that gave them deregulation and bailouts.  Banks had actually successfully lobbied the government for deregulation.  Regulators got captured by those they were supposed to regulate.  Giving financial markets a lot of influence as to how they are regulated.  Giving subsidies to wealthy companies has become known as corporate welfare.  Even with the government assistance, banks blamed the government for the crisis anyway.


How Was The Crisis Handled And Resolved?

Rather than hold accountable the people who were responsible for the crisis to pay for the crisis, the government rewarded the banks for their efforts in ruining the economy.  It was thought inappropriate to have taxpayers who did not contribute to the housing boom, to pay for those who did.  Therefore, the lenders should have paid, because the lenders failed to do their job and assess risk.  The banks claimed that paying for the damages would have impeded the recovery.  Also, the people responsible for the crisis, were put in charge of the repair.  They applied the same ideas that got them into trouble.

The government gave banks money, to enable banks to lend the money out.  But the banks did not lend.  The money was used by banks to pay dividends and bonuses rather than restart lending.  As the banks knew that they might not survive, they just took the money for themselves.  The Federal Reserve even started paying banks interests on their reserves, thereby dampening lending further.

The government did not help the rest of society such as homeowners, unemployed, or alternative ways to stimulate the economy.  Banks claimed to not want to give homeowners bailouts because that would disincentive replaying loans, while at the same time were asking the government for money for themselves.  For an effective stimulus package, it should have been responsive and supported investments to increase jobs.

The government took over various bank assets.  But shifting toxic assets to the government, does not get rid of the toxic assets.  The mortgages were restructured, which stretched payments for which they got more fees.  But this just delayed the consequences. 



Book provides an overview of what happened.  Many popular criticism are made about the financial system, and the arguments are consistent, but there seems to be information missing. 

The author notes various hypocritical contradictions within the claims being made by banks.  Consistent logic, but the claims are being referenced as the financial system rather than the individuals.  As in different people within the financial system can make different and opposing claims, but does not mean that the individuals are making the contradictions.

The proposed solutions would have had their own consequences, and needed to be developed further to be applicable. 

Uses popular assumption because they appear credible, such as claiming that financial services were free and unfettered markets.  Although there were products that did not have appropriate regulations, financial services had been one of the most regulated industries. 


Questions to Consider while Reading the Book

•What is the raison d’etre of the book?  For what purpose did the author write the book?  Why do people read this book?
•What are some limitations of the book?
•To whom would you suggest this book?
•Why did the crisis happen?
•What is the purpose of financial markets?
•How did financial markets fail?
•How did mortgage companies influence the crisis?
•What did banks do with mortgages?
•What is securitization?
•How were rating agencies involved? 
•Why did the financial industry purchase toxic assets?
•Why did lending cease during the crisis?
•Why did banks take high risks?
•Why were banks bailed out?
•What did banks do when they took government money?
•Who was held accountable for the crisis?
•How did the Federal Reserve influence bank lending? 
•How should the government be involved?  
•How should the government have provided stimulus?
•How should the government have responded to the crisis?  

Book Details
Edition:                 First Edition
Publisher:             W. W. Norton & Company
Edition ISBN:      9780393075960
Pages to read:       312
Publication:          2010
1st Edition:           2010
Format:                 Hardcover 

Ratings out of 5:
Readability    5
Content          4
Overall          4