Economic Theory and the Current Economic CrisisJoseph E. StiglitzLindau August 2008

Current economic crisis has many lessons for economists

Probably most serious economic disturbance in U.S. since Great Depression Most downturns since have been inventory cycles

Economy recovers as soon as excess inventories are decumulated Or a result of Central Bank stepping on brakes too hard

Economy recovers as soon as Central Bank discovers its mistake, removes its foot from brake

This economic downturn is a result of major financial mistakes Akin in many ways to frequent financial crises in developing

countries Worse version of S & L crisis

Which lead to 1991 recession Effects spreading to Europe

Partly because of major financial losses in Europe Partly because of exchange rate adjustments, impact on exports Both part of globalization

Pathology teaches lessons Useful in discriminating among alternative

hypotheses Great Depression led to new insights—into how

periods of unemployment could persist Led to conclusion that markets are not self-adjusting

At least in the relevant time frame Role for government in maintaining economy at full

employment Though not consensus on the source of the market failure

Nominal Wage/price rigidities (in tradition of early Hicks) Real wage rigidities (efficiency wage models) Imperfect contracting (Greenwald-Stiglitz/Fischer debt

deflation/Minsky, later Hicks)

Neoclassical synthesis Belief that, once markets were restored to full

employment, neo-classical principles would apply—economy would be efficient

Not a theorem, but a belief Idea was always suspect—why should market

failures only occur in big doses Recessions tip of iceberg Many “smaller” market failures

Imperfect information Incomplete markets Irrational behavior But huge inefficiencies—e.g. tax paradoxes

This is a micro-economic failure leading to a

macro-economic problem Financial markets are supposed to allocate capital

and manage risk Misallocated capital Mismanaged risk Did not create risk products that would have

enabled individuals to manage the risks which they face

Yet they were generously compensated Some 40% of corporate profits

Mismatch between private rewards and social returns (which may be negative)

Understanding market failure General Theorem: whenever information is

imperfect or markets incomplete (that is, always) markets are not constrained Pareto efficient Taking into account costs of collecting and processing

information or creating markets, there are government interventions that can make everyone better off

Pecuniary externalities matter

B. Greenwald and J.E. Stiglitz, “Externalities in Economies with Imperfect Information and Incomplete Markets,” Quarterly Journal of Economics, 101(2), May 1986, pp. 229-264.

R. Arnott, B. Greenwald, and J. E. Stiglitz, “Information and Economic Efficiency,” Information Economics and Policy, 6(1), March 1994, pp. 77-88

Application: Securitization While it enhances opportunities for

diversification, creates new agency problems Resulting market equilibrium will not in

general be (constrained) Pareto efficientOriginator of mortgages did not have sufficient

incentives to screen and monitor

J. E. Stiglitz, “Banks versus Markets as Mechanisms for Allocating and Coordinating Investment,” in The Economics of Cooperation: East Asian Development and the Case for Pro-Market Intervention, J.A. Roumasset and S. Barr (eds.), Westview Press, Boulder, 1992, pp. 15-38.

Application: Lending based on collateral

Increased price of houses gives rise to increased lending Leading to increased demand Leading to increased prices Socially excessive lending Bubbles Similar problems arise in amount of foreign borrowing

(endogenous exchange rates—Anton Korinek)

J.E Stiglitz and M. Miller, “Bankruptcy protection against macroeconomic shocks: the case for a ‘super chapter 11’,” World Bank Conference on Capital Flows, Financial Crises, and Policies, April 15, 1999.

But this does not fully explain what went wrong

Hard to reconcile behavior with rationality Or even rational herding behavior Many borrowed beyond their ability to repay Should have been obvious to both borrower and

lender But those in financial market were supposed to be financially

sophisticated Borrowing based on pyramid scheme—belief that prices

would always go up But how could low income individuals continue to pay more

and more as their real incomes declined?

Zero (or negative) non-recourse mortgages are an option Issuing such options is equivalent to giving away

money Giving away money is hard to reconcile with profit

maximizing behavior Unless there is an underlying belief in the irrationality of

borrower (won’t exercise options) Or of those to whom one will sell the mortgage Or part of a scheme of fraud

Design was an invitation to fraud Conflicts of interest made these more likely But market participants seemed to ignore

Standard models and policy prescriptions used by Central Bank did not anticipate problem

Indeed, they made it worse Denied existence of bubble (a little froth) Encouraged people to take out variable rate

mortgages when interest rates were at record lows With individuals borrowing to capacity And likelihood that interest rates would go up Especially with negative amortization and balloon

mortgages, high likelihood of system blowing up Change in interest rates would lead to defaults, difficulty

refinancing

Denied any ability to ascertain that there was a bubbleEconometric Models to predict economic

vulnerability“Economic Crises: Evidence and Insights from East Asia,” with

Jason Furman, Brookings Papers on Economic Activity, 1998(2), pp. 1-114

Shiller Basic economics—how could prices keep going up

when real incomes of most Americans were declining

Believed in self-regulation—oxymoron Believed that if there was a problem, it would be

easy to fix Argued that interest rate was too blunt of an

instrument If tried to control asset price bubble, would interfere

with focus on current markets But refused to use instruments under its disposal

Regulatory instruments rejected Even though one Fed governor tried to get them to act

Central banks were focused on models centered on second-order problems —micro-misallocations that occur when relative prices get misaligned as a result of inflation

First-order problem was integrity of the financial system

Why is this a problem?

Standard model (representative agent models) without institutions says this is no problem Misallocations couldn’t have happened Were acting on best information available Simply a negative shock Some redistributions But redistributions don’t matter Economy simply goes on with new capital stock as if

nothing had happened

Redistributions and institutions do matter

Loss in bank equity will not be readily replaced Heavy dilution demanded Consistent with theories of asymmetric information

Asquith and Mullins; Greenwald, Stiglitz, and Weiss “Informational Imperfections in the Capital Markets and Macroeconomic Fluctuations,” American Economic Review, 74(2), May 1984, pp. 194-199.

With loss of bank capital, there will be reduced lending Greenwald and Stiglitz, New Paradigm of Monetary Economics

What matters is not just interest rates but credit availability Credit availability also affected regulations (capital adequacy

requirements) and risk perceptions As important as open market operations and interest rates Spread between T-bill rate and lending rate an endogenous variable

With reduced lending, reduced level of economic activity

Problems exacerbated by reduction in interbank lending Tightening credit constraints and leading to higher

lending interest rates Banks know that they don’t know own balance sheet And so can’t know balance sheet of others But there are still high levels of information

asymmetries Market breakdown

Stiglitz and Weiss, “Credit Rationing in Markets with Imperfect Information,” American Economic Review, 71(3), June 1981, pp. 393-410

Akerlof, Lemons.

Credit interlinkages As important as interlinkages emphasized in standard

general equilibrium model Not fully mediated through price system Bankruptcy in one firm can lead to bankruptcy in others

(bankruptcy cascades) Collapse of economic system Worry underlay bail-outs (1998 LTCM, 2008 Bear Stearns)

Agent-based models more likely to bring insights No hope from representative agent models

S. Battiston, D. Delli Gatti, B. Greenwald and J.E. Stiglitz ,“Credit Chains and Bankruptcy Propagation in Production Networks,” Journal of Economic Dynamics and Control, Volume 31, Issue 6, June 2007, pp. 2061-2084

It will take time to restore bank capital, and therefore for full restoration of economy

B. Greenwald and J. E. Stiglitz, “Financial Market Imperfections and Business Cycles,” Quarterly Journal of Economics, 108(1), February 1993, pp. 77-114.

Pace will be affected by magnitude of fiscal stimulationMoney to those who are credit constrained

(unemployed)Would not work if Ricardian equivalence held

or if redistributions didn’t matter

Pace will also be affected by government sponsored capital injections Hidden in bail-outs, huge wealth transfers

Many banks focusing on selling “bad assets” By itself, doesn’t solve capitalization problem, only reduces

uncertainty They seem to be paying a high price

American bail-outs particularly non-transparent With credit and interest rate options embedded Access to Fed window by investment banks Discriminatory patterns?

What was going on? Macro

At macro-level—insufficient aggregate demand induced Fed to flood economy with liquidity and have lax regulations, to keep economy going Created new bubble to replace dot.com bubble Lower interest rates major effect on mortgage equity

withdrawals, much of which was consumed Decline in net worth, unlike case where investment is

stimulated

High level of demand for U.S. dollars to put in reserves

Massive reserve accumulation Partly in response to IMF/US treasury response to

1997/1998 crisis But exporting T bills rather than automobiles does

not create jobsHigh oil prices

Massive redistribution to oil exporters If redistributions don’t matter, wouldn’t have any

consequences But redistributions do matter Part of global imbalances But real side of imbalances—inadequate global

aggregate demand

Myopic, short-sighted response Akin to how Latin America avoided negative impact of oil

price shock—borrowing for consumption Paid a high price—lost decade

Housing bubble fueled consumption boom that offset higher expenditures on oil, large trade deficit—for a while

Not sustainable There were alternatives—none of this was inevitable

See J. E. Stiglitz and Linda Bilmes, The Three Trillion Dollar War: The True Cost of the Iraq Conflict, W.W. Norton, 2008

What was going on? Micro

Regulatory arbitrage—financial alchemy converting F rated toxic mortgages into financial products that could be held by fiduciaries had a private (but not necessarily social) pay-off

Accounting arbitrage—bonuses based on reported profits, incentive to book profits (e.g. from repackaging), leaving unsold (risky) pieces “off balance sheet”

Distorted incentive systems

HARD TO EXPLAINHARD TO EXPLAIN How markets used models that were so bad

Underestimated systemic risk Underestimated obvious correlations Underestimated fat tail distributions Overestimated value of insurance (undercapitalized

insurance companies) Underestimated potential consequences of conflicts

of interest, moral hazard problems, perverse incentives and scope for fraud

Appraisers owned by originating companies Rating agencies paid by those producing products

Intellectual incoherenceArgued that they had created new products

that transformed financial markets Justified high compensation

Yet based risk assessments on data from before the creation of the new products

Argued that financial markets were efficientBased pricing on spanning theorems Yet also argued that they were creating new

products that transformed financial markets

HARD TO EXPLAINHARD TO EXPLAIN

It was individually rational for those in finance to take advantage of flawed incentive structure—but not good for the system

Even if those originating mortgages had flawed incentives, why didn’t investors buying mortgages exercise better oversight?

Repeated failures

HARD TO EXPLAINHARD TO EXPLAIN

Markets still have not made available mortgages that would have helped individuals manage the risks which they face

There are alternatives that do a better jobDanish MortgagesVariable rate, fixed payment, variable maturity

Regulatory Failure

Using wrong models Focusing on wrong thing Ideological—appointed partly because of

commitment to non-regulation Political—when appointment was made,

implications for campaign contributions played key role in appointment

Political (special interest) role in design of Basel II regulations—not “just” technocratic

Beyond regulatory capture

Regulatory capture model provides too simplistic model of what happened

There was a party going on, and no one wanted to be a party pooperBut Fed not only failed to dampen party, but

kept it going It had alternatives

Going forward Actions by market participants generated externalities

Costs borne by taxpayers Those who are losing their jobs Social problems—millions of Americans losing homes

Whenever there is an externality, grounds for government intervention

Those in the financial sector would like us just to build better hospitals, but do nothing about prevention and contagion

Can we design interventions that encourage “good” innovation (questionable value of much of recent financial innovation)?

Can we avoid “political economy” problems that have marked past regulation?

Regulatory systems have to recognize asymmetries of information, and asymmetries of salaries

Regulation

IncentivesConflicts of interestLonger term

BehaviorsSpeed bumpsRetaining some responsibility for financial products

created Accounting

Reducing scope for off balance sheet activity

Structures Financial product safety commission

With representation of those who are likely to be hurt by “unsafe” products

Skills required to certify “safety” and “effectiveness” different from those entailed in financial market dealing

Financial market stability commission Need separate market regulators because complexity

of each market requires specialized regulators But need oversight, to understand interactions among

pieces (systemic leveraging, regulatory arbitrage)

Financial market regulation is too important to leave to those in the financial sector alone

Some aspects need to be approached on a global level IMF and Basel failed to provide adequate

regulatory frameworkNotion underlying Basel II that banks could be

relied upon to assess their own risk seems, at this juncture, absurd

Rich research agenda ahead Exploring financial interlinkages

Bankruptcy cascades Optimal network design (preventing contagion)

Designing financial instruments that better reflect information imperfections and systematic irrationalities

Designing appropriate mix of financial institutions Taking into account local information Need for renegotiation Asymmetries of information created by securitization

Rich research agenda ahead

Macro-economic models that take into account complexity of financial system Including financial linkagesRecognizing role of banksAnd the consequences of redistributions Information imperfections, bubbles (rational

herding and irrational)

Research and Policy Agenda Unfettered financial markets do not work

But regulation and regulatory institutions failed Design of better regulations

Not only designed to discourage destructive behaviors

But to encourage financial system to fulfill its core mission

May require more extensive intervention in markets Design of better regulatory institutions

Based on a theory of regulation that is better than simplistic “capture” theory

Which itself should be an important subject of study

Our financial system failed in its core missions—allocating capital and managing risk

With disastrous economic and social consequences Huge disparity between potential and actual GDP

We must do better And a successful research agenda will help us to

do that