We have all heard of Joseph Stiglitz; the Nobel prize winning economist who releases books every now and then. You may also be familiar with his belief in more regulation for the economy and his criticism of President Obama’s rescue plan for the financial industry, famously remarking that whoever came up with it is “either in the pocket of the banks or they’re incompetent.”
It should also come as no surprise that Stiglitz holds globalization in contempt, especially given the title of his most famous book: “Globalization and its discontents”. While he argues some of the same points in his newest book “Freefall”, neither of these interest us at the moment. We are more interested in his advocacy of “Financial Circuit Breakers”. In a recent paper, he writes that full separation of markets is preferable to full integration.
To be fair, he deals with extremes (either complete separation or complete integration), but we find such a statement rather short sighted nonetheless. Apart from the fact that it flies into the face of 200 years of economics and around 4,000 years of history, his analogy with circuit breakers seems very worrisome. Circuit breakers are operated by a central location that decides when and where to allow the flow. Financial markets comprise of millions of participants. We have seen how disruption of the flow of electricity in just one location can have disastrous consequences (the blackouts in recent years in California and New York), as well as in other industries (oil production in the Middle East and gas production flowing from Russia). Is this really our solution for Financial Markets?
Full paper available here.
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I’m not sure I would agree with your characterization of this paper’s central argument: while Stiglitz does say, “Indeed, faced with a choice between two polar regimes…autarky may be superior”, his position, stated at the outset and conclusion, is simply that “full integration is not in general optimal.”
Another reason I am not sure I agree with you is that I cannot claim to follow Stiglitz’ arguments all the way through. This is not a paper for day-trippers to the land of Economics. Even for the reader who is comfortable with all the referenced theories and models (many of them Stiglitz’ own), and who knows all about non-convexities, the mathematics of the Canonical Model will surely give pause.
Nonetheless, non-numerate readers can question the solutions presented, i.e. externally-imposed circuit breakers and less integrated markets. Stiglitz states the central problem facing all market players and economists: “As our financial system became increasingly intertwined, through complex credit default swaps and other derivatives, too little thought was given to these matters, by the financial wizards that were creating the new products, by the bankers that were marketing them, by the economists that were touting their virtues, and by the regulators and policymakers who were responsible for ensuring the overall stability of the system.” He also mentions the herd instinct and player reward systems which compounded the problem.
Stiglitz argues for placing buffers between markets to reduce contagion. While it is true that a firewall may temporarily protect passengers from an automobile engine fire, it is no longer helpful when the car blows up. Likewise, a clearing facility will cushion the shock of individual failures. But when there is a run on the clearing house from multiple, simultaneous defaults, the entire system can fail, threatening all component members. Surely then it is better to have risk spread as wide as possible through a broad, integrated market, with each player assuming responsibility for “giving thought to these matters”, i.e. reducing the reliance on mathematical models, and diversifying investment decision criteria.
Well I did mention that he was dealing with two extreme situations (and he admitted to doing so himself).
As much as I would like to attempt tackling it, I will also refrain from challenging his canonical model. I do think, however, that this shows a somewhat “academic” lack of awareness of real life situations. When his example states that autarky is more favorable than complete integration, yet centuries of history point in the opposite direction, I get the feeling he relies a tad too much on his mathematical models (in fact it looks like he is basically combining several other models and assuming they will work together).
If one applies an economic model to the real world, there is a chance that one’s projections will still be incorrect. When history has already proven the models’ conclusions not to be correct, the chances of being incorrect seem substantially higher.
In other words, his equations may be perfectly correct, but we are just waiting to find the real life x-factor that proves them wrong.
Having said that, I think you also point out a valid flaw in his logic, in that limiting the scope of the market might limit the risk, but it will also concentrate it much more.