Lessons from the sub-prime crisis

Barry Ritholtz points attention to the most succinct and precise summary of the lessons from the sub-prime mortgage crisis and the events of its tumultuous aftermath, from Joseph Stiglitz

1. Markets are not self-correcting, and without adequate regulation, they are prone to excess.

2. There are many reasons for market failures. Too-big-to-fail financial institutions had perverse incentives - privatized gains, socialized losses. When information is imperfect, markets often do not work well – and information imperfections are central in finance. Externalities are pervasive: the failure of one bank imposed costs on others, and failures in the financial system imposed costs on taxpayers and workers all over the world.

3. Keynesian policies do work. Countries, like Australia, that implemented large, well-designed stimulus programs early emerged from the crisis faster

4. There is more to monetary policy than just fighting inflation. Excessive focus on inflation meant that some central banks ignored what was happening to their financial markets. The costs of mild inflation are miniscule compared to the costs imposed on economies when central banks allow asset bubbles to grow unchecked.

5. Not all innovation leads to a more efficient and productive economy – let alone a better society. Private incentives matter, and if they are not properly aligned, the result can be excessive risk taking, excessively shortsighted behavior, and distorted innovation... Financial engineering did not create products that would help ordinary citizens manage the simple risk of home ownership... Instead, innovation was directed at perfecting the exploitation of those who are less educated, and at circumventing the regulations and accounting standards that were designed to make markets more efficient and stable. As a result, financial markets, which are supposed to manage risk and allocate capital efficiently, created risk and misallocated wildly.