Here’s a couple excerpts from an excellent article on our financial system, published in The New Republic:
Falling Down
By Joseph Stiglitz*
No manufacturing. No new ideas. What’s our economy based on?
"More than 75 years ago, confidence in the market economy got a rude shock as the world sank into the Great Depression. Adam Smith had said that the market led the economy, as if by an invisible hand, to economic efficiency and societal wellbeing. It was hard to believe that Smith was right when one in four Americans was out of a job. Some economists held true to their faith in self-regulating markets; they said, just be patient, in the long run the market’s restorative forces will take hold, and we will recover. But Keynes’s retort ruled the day: In the long run, we are all dead. We could not wait. Today, even conservatives believe that government should intervene to maintain the economy at or near full employment.
Those who believe in free markets have now received another rude shock: We have not yet sunk into an "official" recession, but it has been more than half a year since any new jobs were created, and, meanwhile, our labor force continues to grow. If the Great Depression undermined our confidence in macroeconomics (the ability to maintain full employment, price stability, and sustained growth), it is our confidence in microeconomics (the ability of markets and firms to allocate labor and capital efficiently) that is now being destroyed. Resources were misallocated and risks were mismanaged so severely that the private sector had to go running to the government for help, lest the entire system melt down. Even with federal intervention, I have estimated the cumulative gap between what our economy could have produced–had we invested in actual businesses, rather than, say, mortgages for people who couldn’t afford their homes–and what we will produce over the period of our slowdown to be more than $1.5 trillion.
Blame has rightly fallen on the financial markets because it is their responsibility to allocate capital and manage risk, and their failure has revived several old concerns of the political (and economic) left. 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…."
…"To put it another way, had those in the financial sector allocated capital and risk in a way that fueled the economy, they would have had handsome profits. But they wanted more, and so established incentive structures that encouraged gambling. If they gambled and won, they could walk away with a share of the profits. If they gambled and lost, the investors would bear the consequences. It was almost as if the entire financial system was converted into a giant casino in which the system was rigged to guarantee those running the games huge returns, at the expense of the players. 
But in Las Vegas and Atlantic City, the games are near zero-sum: The gains of the casino owners approximately equal the losses of the players.
The financial-system-as-casino, on the other hand, is a negative-sum game. Those on Wall Street may have walked off with billions, but those billions are dwarfed by the costs to be paid by the rest of us. Some have lost their homes and life savings–to say nothing of their dreams for their own futures and those of their children. Others are innocent bystanders who resisted the false promises of the mortgage brokers and the credit card companies, but now find themselves out of jobs as the economy weakens. And the poor are hurt as state revenues plummet, forcing cutbacks in public services."…
Full article here.
Joseph Stiglitz is University Professor at Columbia University, winner of the 2001 Nobel Memorial Prize in Economics, and co-author of The Three Trillion Dollar War.
