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STIGLITZ, Joseph

Freefall

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Indeed the financial sector had incentives to take risks that combined a large probability of an above normal return with a small probability of disaster. If things could be designed to make it likely that the disaster would occur sometime in the distant future, so much the better. The net return could even be negative, but no one would know it until it was too late. Modern financial engineering provided tools to create products that perfectly fit this description.

An example may illustrate. Assume that one could invest in a safe asset with return of 5 percent. The finance wizards designed a product that yielded 6 percent almost always-say 90 percent of the time. Magically, they seem to have beaten the market, and by an amazing 20 percent. But in the remaining 10 percent of the time - everything was lost. The expected (average) return was negative (-4.5 percent), far below the 5 percent of the safe asset. But, on average, with the bad returns occurring only one year out of ten, it will be a decade before the disastrous outcome occurs - a long time during which the financial wizards can reap ample rewards from their amazing ability to beat the market.

The disaster that grew from these flawed financial incentives can be, to us economists, somewhat comforting: our models predicted that there would be excessive risk-taking and shortsighted behavior, and what has happened has confirmed these predictions. ...The misalignment between social and private returns was clear: financial marketeers were amply rewarded but had engaged in such egregious risk-taking that, for the economy as a whole, they had created risk without reward.

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