Joseph E. Stiglitz Shanghai May 14, 2009 Keys to Future Stability and Growth : LESSONS FROM THE GLOBAL ECONOMIC CRISIS

Failures of America’s Financial System  Didn’t manage risk—created risk  Misallocated capital Too much into housing, too little to real investment, innovative sector, improving environment  High transaction costs Resisted creation of an efficient electronic transfer system  Predatory lending practices

Failures of America’s Financial System  Innovations directed at regulatory, accounting, and tax arbitrage Little innovation at meeting society’s real needs ○ For example, managing the risk of most family’s most important asset—their home  Failed at both micro and macro level  Major social problems—devastation of the poor in America  Global macro-problem

“Model” didn’t work  Self-regulation didn’t work Perverse incentives Self-regulation can’t work—externalities  Model of risk diversification (securitization) didn’t work Increased information asymmetries Systems of market checks and balances failed (credit rating agencies) Regulatory checks and balances failed ○ Ideology ○ Capture

The current crisis and where the system failed  Incentives Market participants had incentives to engage in excessive risk taking/short sighted behavior Conflicts of interest  Transparency Market participants had incentives and instruments for non-transparency But failure was more than that of transparency: complexity  Competition Too big to fail institutions had incentives to engage in excessive risk taking Competition didn’t work—race to the bottom

What are the key factors in the design of a new regulatory structure and system ?  Asymmetries and imperfections of information  Moral hazard  Human fallibility/ “behavioral” economics  Externalities

Creating a 21 st century financial system  As America went about saving its financial system, it should have asked, what kind of a financial system did it want for the future Couldn’t, shouldn’t go back to the failed system of the past At the very least, downsizing scale Question—which parts to downsize? ○ Some worked well—they should be expanded

Creating a 21 st century financial system  China needs to ask same question today as it creates a new regulatory structure  An “ecology” of financial institutions serving different needs

Key functions of financial regulation  Safety and soundness of individual institutions (micro-prudential regulation)  Macro-stability (macro-prudential regulation) Manner in which micro-prudential regulation had been conducted undermined macro- stability  Competition  Consumer/investor Protection  Access

Key features of new regulatory system  Regulation has to be comprehensive Globally, domestically Products, Institutions  Transparency  But transparency is not enough--complexity  Restrictions on incentives—including incentives that encouraged lack of transparency, excessive risk taking, short sighted behavior

 Restrictions on size  Restrictions on risk taking  Financial product safety commission

Key principles to be safeguarded/ put in place  Mark-to-market—best information available Care in regulatory use of information Care in design of mark to market system  Restrict or inhibit the use of over-the- counter derivatives  Restrictions on leverage, countercyclical provisioning/capital adequacy  Have the voice of those whose interests are likely to be hurt be well represented in the regulatory structure

 A good regulatory system can contribute to a more dynamic, innovative economy, a more efficient economy, a more stable economy, and a more “harmonious” society  Can’t return to the world as it was before the crisis

But more than financial regulation is required  Corporate governance Failures led to flawed incentive structures ○ Which didn’t serve shareholders or customers well  Anti-trust policy Not just concerned with market power But risks imposed on society And political power ○ Original concern in the creation of anti-trust policies

And more than regulation is required  Government may have to take a more active role in finance Creating an efficient electronic transfer mechanism Lending to the poor—temptation for predatory lending too great Providing good risk products (Danish mortgages, inflation indexed bonds)

CHANGING GLOBAL LANDSCAPE  China likely to remain major global creditor/major source of savings in global economy  Makes sense for intermediation services to be provided in country doing savings  Especially natural to raises questions about intermediation through US Financial system there failed Instability of dollar may be increasing

Rethinking our Financial System  America’s financial system failed—at great cost to America and the world  It is important for America and all other countries to learn the right lessons  There had been a race to the bottom  We should now have a race to the top  What is at stake is not just a matter of economic stability and growth  But social stability and a harmonious society