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The Author Speaks: Financial Armageddon? Bailout Smailout? Freezing the Financial Meltdown?

The economy President Obama inherited just over a year ago seemed to be wavering on life support: Home prices had buckled. Month after month, unemployment kept rising. The banking system was in a deep freeze, unwilling to extend credit to small-business owners and wounded by a growing pool of bad loans. And banks themselves were trying to calculate the extent of their losses in the mortgage market.

As a new president, Obama faced dual challenges. Could he turn the economy around? Then, could he implement fundamental reforms in our financial system to prevent another crisis in the future?

In his new book Freefall, Nobel Prize-winning economist Joseph Stiglitz evaluates the Obama administration’s performance on both counts. We have good reason to listen. A decade ago, as chief economist for the World Bank, he warned that the Asian financial crisis could well be a warm-up for broader financial crises like the one from which America is only slowly emerging.

Now a professor at Columbia University, this “insanely great economist,” as fellow Nobel laureate Paul Krugman calls him, spoke with the AARP Bulletin about his thoughts on the economy today and in the future.

(Read an excerpt here.)

Q. We’ve been in a crisis for well more than a year. Evaluate the Obama administration’s response.

A. The Obama administration so far has wasted the crisis, in the sense that it didn’t use that opportunity to understand what was wrong, what had brought us to the crisis, to articulate that, and to use that as the basis for a set of reforms that would have strengthened our economy and made a future crisis less likely.

Q. What should the administration have done?

A. They should have begun by articulating a vision of what a financial sector ought to do, which would include key issues like providing credit to small- and medium-size business enterprises. It would have centered more on local banks that are more closely tied to the community in which they operate. It would have paid attention to the venture capital firms that are key to starting up new enterprises, as opposed to speculators in the market.

Q. What hasn’t been done?

A. We have not reformed any of the regulations regarding securities law that are associated with the massive mistakes before the crisis. Instead, we have let “too big to fail” banks grow bigger. Meanwhile, we’ve let 140 of the smaller banks last year alone fail. So we have a financial system that in some ways is more dysfunctional than it was before.

Q. What’s the result?

A. Credit is weaker. Small businesses have less access to capital. That leads to a cycle of debt and deflation. Because excessive risk-taking has not been curtailed, there is clearly the potential for another crisis.

Q. What do you recommend?

A. First, we need another stimulus. One out of six Americans wanting a full-time job and not being able to get one is unacceptable. The $18 billion jobs bill is just too small to make a real dent. About 8 million jobs have been lost since the beginning of the crisis, and we have a million new entrants into the labor market every year. So the jobs deficit is about 10 million.

Q. What else?

A. Second, we have to do something about the mortgages. Again, what the Obama administration did is better than nothing, but it hasn’t stemmed the bleeding. The numbers of mortgage foreclosures expected in 2010 is larger than those in 2009 or 2008. We’re talking about something in excess of 2.5 million foreclosures. The administration didn’t deal with the core problem of houses underwater, where the owner owes more than the value of the property.

The banks didn’t want us to do anything because doing something would force recognition of their bad lending practices. We have a bankruptcy procedure—Chapter 11—for companies to get a fresh start. I’d call for a homeowners’ Chapter 11.

Q. What about regulating the banks?

A. Right now there’s a whole set of regulatory changes being proposed to level the playing field. If you’re too big to fail, then you shouldn’t be allowed to get access to capital at a cheaper rate, like the way Citibank received massive government support. Let’s tax them, break them up and regulate them to make sure they don’t engage in excessive risk-taking. And let’s do something about these highly risky credit derivative swaps (in which banks make enormous “side bets” on whether bonds might default) that caused the massive bailout of AIG.

Q. How will the recession play out differently among age groups?

A. This crisis is very viciously affecting a lot of different segments. The two segments affected most are those just graduating and those in their 50s and 60s, for different reasons.

Q. How is it affecting the boomers?

A. Some AARP members are already affected by the major decline in the stock market. For most Americans, housing is their great asset, and now their home equity is negative or very greatly diminished. They may get by on Social Security, but all those dreams of the great vacation, or helping their grandchildren, are destroyed.

Also, firms think they can get away with laying off those who are costly. So you lay off people in their 50s and keep the 30-year-old worker who isn’t as good but cheaper.

Q. What about those just entering the job market?

A. Young people just can’t get a job. The evidence suggests they will never catch up. Once unemployed, they’re going to find it more difficult to get back into the labor market forever.

Q. Who else is affected?

A. Anyone who acted prudently, you could argue, and put their money in Treasury bills. The returns are now down to 1 percent. How can they live on that? We have saved the banks on the backs of our elderly. The bailout funds represent a direct transfer from all those prudent people who saved, to our bankers. The banks weren’t thinking about the harm they were doing to our elderly, but that’s effectively what they did.

Q. You make it clear that America has lived beyond its means and faces a day of reckoning. On the other hand, you want more government spending to get us out of recession. How do you resolve the tension?

A. It’s sad that we spent so much money beyond our means, but here we are and we have to look forward. This is the time to do investments in things like the electrical grid and solar power. If we borrow money for investments, our productivity and incomes will increase. For every dollar we spend, economic output goes up by about two dollars. That means we get returns not only in the short run, but also in the long run.

Q. What about critics who worry that we are piling on too much debt?

A. We ought to be focusing on the long-term national debt. All it takes is about 5 to 6 percent return on these investments for long-term debts to be actually decreased as a result of this spending, because as the economy grows, tax revenues grow more than enough to pay back the deficits from the borrowing we’ve undertaken.

Q. What else should investments target?

A. Technology and education. I’m very concerned that one of America’s real strengths—the quality of higher education and our research universities—is now taking a very big hit. Private universities have lost 25 percent, sometimes 30 percent of their endowments. They are cutting back. State universities are being cut back because states have balanced budget requirements. This is the time we should be investing in these high-return areas.

Q. What happens when the attention of the electorate wanders away from how this crisis began and the banking industry has well-funded lobbyists to keep government regulation at bay?

A. The bankers start doing well and they have the money to invest in making sure the world winds up the way they want it. And the middle class doesn’t have the money. So the richer the rich get, the more money they have to invest in political processes. This is a very destructive and dangerous dynamic.

Q. Are you optimistic that a real recovery is setting in?

A. The third and fourth quarters of 2009 saw positive growth, but unemployment hasn’t moved down significantly. And that growth over 2010 and 2011 won’t be robust enough to reduce unemployment anywhere near the way it should. Pressure to reduce deficits means we won’t be able to deal with the fiscal stimulus in the way that we ought to.

Q. Are any jobs safe havens?

A. Because people will continue to ask us “where are we going?” the only industry that will be having a field day will be the economics profession.

Michael Zielenziger writes on the economy and lives in Oakland, Calif.

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