How free markets sank the U.S. economy

The Wall Street sign is seen in front of the New York Stock Exchange, October 8, 2009 file photo.

NEW YORK (Reuters) - Two years ago, a poisonous brew of bad economics, lax regulation, and egregious behavior boiled over, scalding the financial system and pitching the United States into its steepest downturn since the Great Depression.

The antidotes to the crisis, concocted by many of the players who stirred the original toxic brew, have pulled the U.S. economy back from the brink.

But those remedies won't prevent future crises, Joseph Stiglitz, winner of the 2001 Nobel Prize for Economics, writes in "Freefall: America, Free Markets, and the Sinking of the World Economy" (Norton, $27.95).

In contrast to the regulations that emerged from the Great Depression, which promoted growth and stability, the response to this crisis has led to a less-competitive financial system dominated by banks that are too big to fail, he writes.

Stiglitz, former chief economist at The World Bank and now a professor at Columbia University in New York, focuses on banks' failure to assess and manage risk, especially when risk is disguised by complex financial instruments. Such "modern alchemy" transformed risky sub-prime mortgages into A-rated products dubbed safe enough to be held by pension funds, he says.

America's financial markets also failed to allocate capital productively, he says. "At their peak in 2007, the bloated financial sector absorbed 41 percent of profits in the corporate sector," Stiglitz writes.

To add insult to injury, some of those profits were spent influencing Congress to make certain the government would not regulate risky derivatives or curb predatory lending.

Finally, flawed incentive structures fostered corruption, encouraging deceptive accounting that would lead to higher stock prices and higher bonuses for Wall Street managers.

By 2008, the nation's economy was in a freefall and the United States, a country that purported to revile socialism, had to socialize the risks banks had taken and intervene in markets in unprecedented ways, Stiglitz writes.

But where does that leave the financial system and, more importantly, the U.S. economy?

"It's very likely we will have a very slow recovery, I hope not as protracted as the Japanese did, but no one thought in 1990 that they would have one that long either," Stiglitz said in a recent conversation with Reuters.

Japan is viewed as having lost a decade of growth during the 1990s before the economy bounced back in 2004-06.

Stiglitz said one difference between Japan and the United States is that Japan has zero labor force growth, while the United States has a 1 percent labor force growth rate.

Thus, if U.S. jobs grow at a 1 percent pace, "it's as bad as Japan's growing at zero percent," he said.

Other differences exist between Japan and the United States, some of which argue for a quicker comeback for the United States and others than point to a slower one, Stiglitz said.

For one thing, while Japan could export its way out of its slowdown, the United States cannot because European growth is also slow.

For another, Japan began its recession with a high savings rate and that enabled it to expand by decreasing savings and increasing consumption.

"The United States is in the opposite situation, having begun with a savings rate of zero," Stiglitz said. "Thus, the likelihood that our savings rate is going to go up is very high and rising savings can contribute significantly to a prolonged slowdown."

The healthcare situation in the United States, with its issues of equity and access, also has implications for U.S. growth, Stiglitz told Reuters. Health affects productivity, and the cost of healthcare affects competitiveness, he said.

"To make things worse, we have made the fundamental mistake of linking the provision of healthcare to employment, creating strong interactions between deficiencies in the health care system and problems in the labor market," he said.

The solution to that problem would be to move to a single payer system that recognizes health as a social cost, not an employment cost, Stiglitz said.

"Providing low-skilled workers who earn minimum wage with health insurance almost doubles the cost of employing them so the adverse affects of the current system are most marked on the low-wage part of the labor force," he said.

But the biggest risk to the economic recovery is the "very, very strong political risk" posed by those who argue for deficit reduction, he said.

"President Obama is trying to walk a very fine line on that issue now, saying he will cut the deficit over the long run and stimulate the economy over the short run," he said. "But the myopia of the deficit hawks won't let them buy into that."

(Reporting by Ellen Freilich; Editing by Eddie Evans)