36HARPER’S MAGAZINE / NOVEMBER 2008
From the seventeenth-century tulip mania tothis century’s housing bubble, economies havebeen susceptible to the quest for the easy buck.Clever people will invariably circumvent regula-tions and accounting standards; they will seizeopportunities to prey upon the poor and the ill-informed, to proﬁt by selling the notion of the freelunch. By now most people are aware that over thepast ﬁve years the ﬁnancial sector has made badloans and extremely risky bets, that defaults on theloans and record losses on the bets have serious-ly damaged the nation’s (and the world’s) econ-omy. The downturn is likely to be so severe part-ly because we have succumbed to the opinionthat markets work best by themselves, unfetteredby government regulations. But the people mak-ing this argument are the ones who have beenserved well by it. We can do far more to protectagainst self-interest. In particular, we need to im-prove the incentives that drive those in the ﬁnanceindustry, so that their interests align with those of the society and economy they are meant to serve.The ﬁnancial sector is supposed to allocate cap-ital judiciously, making sure that it goes to areaswhere returns, when adjusted for risk, are highest.When capital is well distributed in this way, theeconomy is more likely to ﬂourish in the shortterm and grow steadily over time. Capital marketsare also supposed to manage risk, transferring itfrom those parties less able to bear it to those thatare more able to do so; distributing risk in this man-ner encourages entrepreneurship and stabilizesthe economy. In return for performing this pub-lic service, the ﬁnancial markets are generouslyrewarded—in recent years they have garnerednearly a third of all corporate proﬁts.The ﬁnancial system is
to do thesethings. But it is clear that America’s ﬁnancialinstitutions have not managed risk; they havecreated it. The industry allocated hundreds of billions in bad loans to an inﬂated housing mar-ket, resulting in the greatest number of foreclo-sures since the Great Depression. With economicgrowth currently at a dreary 1 percent, there is al-ready an immense gap between what we are nowproducing and what we could be producing if this crisis had not occurred—a cumulative loss Iestimate will be in excess of $2 trillion.Too many bankers and other lenders have beenfocused on trying to beat the system by gettingaround accounting and banking regulations(through what is called accounting and regulato-ry arbitrage). Indeed, with bonuses based on short-term proﬁts, they had every incentive to gambleand connive. And now that there’s a bust, no oneis being asked to pay back the hefty bonuses earnedduring the boom. On the contrary, even as theyare dismissed, those who helped send their ﬁrmsand the American economy into a tailspin arerewarded with generous severance packages. Theyare enriched regardless of what happens to in-vestors, homeowners, and others who lost so much.Unless we reform incentives, the ﬁnancial sectorwill only try to circumvent whatever new regula-tions are put in place. We will simply have a shortrespite before the next crisis.One major problem with incentives involvessecuritization. The selling and reselling of mort-gages, with payments chopped into thousands of pieces, creates a new set of information asymme-tries, as buyers of securitized mortgages have less in-formation than the originators of the mortgages.To be sure, both investors and regulators shouldhave recognized the scam. But as mortgage origi-nators realized that buyers of securitized mortgagespaid little attention to who was taking out theloans and on what terms, they pushed through asmany loans as they could, regardless of their risk,and they invented ever more complex and pre-
Joseph E. Stiglitz is University Professor of Economics atColumbia University and winner of the 2001 Nobel Prizein Economics. His most recent book, with Linda Bilmes,is
The Three Trillion Dollar War: The True Cost of theIraq Conﬂict.
Illustrations by Raymond Verdaguer
realign the interests of wallstreet
By Joseph E. Stiglitz