by Calculated Risk on 9/03/2008 05:05:00 PM

Professor Stiglitz writes in the New Republic: Falling Down. (hat tip Justin)

Stiglitz makes several thought provoking arguments. He points out that financial manager incentives encouraged gambling:

Perhaps the worst problems--like those in the subprime mortgage market--occurred when non-transparent fee structures interacted with incentives for excessive risk-taking in which financial managers got to keep high returns made one year, even if those returns were more than offset by losses the next.

Professor Hamilton and others have been warning about these incentives for several years (see Hamilton's Hedge fund risk and Wharton Professor Dean Foster and Oxford Professor Peyton Young's Hedge Fund Wizards).

But the following passage is key (and very optimistic!). I hear the argument all the time that the U.S. needs to increase it's manufacturing base. I agree with Stiglitz:

Some looking at the U.S. economy's decreasing reliance on manufacturing and increasing dependence on the service sector (including financial services) have long worried that the whole thing was a house of cards. After all, aren't "hard objects"--the food we eat, the houses we live in, the cars and airplanes that we use to transport us from one place to another, the gas and oil that provides heat and energy--the "core" of the economy? And if so, shouldn't they represent a larger fraction of our national output?

The simple answer is no. We live in a knowledge economy, an information economy, an innovation economy. Because of our ideas, we can have all the food we can possibly eat--and more than we should eat--with only 2 percent of the labor force employed in agriculture. Even with only 9 percent of our labor force in manufacturing, we remain the largest producer of manufactured goods. It is better to work smart than to work hard, and our investments in education and technology have enabled us to enjoy higher standards of living--and to live longer--than ever before.

Exactly. Innovation is the key.