Joseph E. Stiglitz Shanghai May 14, 2009

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

2. 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

3. 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

4. “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

5. 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

6. 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

7. Creating a 21st 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

8. Creating a 21st 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

9. 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

10. 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

11. Restrictions on size • Restrictions on risk taking • Financial product safety commission

12. 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

13. 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

14. 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

15. 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)

16. 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

17. 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