Transcript Economic Theory and the Current Economic Crisis

Economic Theory
and the Current
Economic Crisis
Joseph E. Stiglitz
Lindau
August 2008
Current economic crisis has many
lessons for economists

Probably most serious economic disturbance in U.S.
since Great Depression
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Most downturns since have been inventory cycles
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Or a result of Central Bank stepping on brakes too hard
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Economy recovers as soon as excess inventories are decumulated
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
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Akin in many ways to frequent financial crises in developing
countries
Worse version of S & L crisis
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Which lead to 1991 recession
Effects spreading to Europe
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Partly because of major financial losses in Europe
Partly because of exchange rate adjustments, impact on exports
Both part of globalization
Pathology teaches lessons
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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
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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
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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
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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
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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
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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
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40% of corporate profits
Mismatch between private rewards and social
returns (which may be negative)
Understanding market failure
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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
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While it enhances opportunities for
diversification, creates new agency
problems
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Resulting market equilibrium will not in
general be (constrained) Pareto efficient
 Originator 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
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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
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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
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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?
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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
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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
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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
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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
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Change in interest rates would lead to defaults, difficulty
refinancing
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Denied any ability to ascertain that there
was a bubble
 Econometric
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
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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
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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
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Why is this a problem?
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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
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Loss in bank equity will not be readily replaced
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Heavy dilution demanded
Consistent with theories of asymmetric information
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With loss of bank capital, there will be reduced lending
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Greenwald and Stiglitz, New Paradigm of Monetary Economics
What matters is not just interest rates but credit availability
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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.
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
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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
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Stiglitz and Weiss, “Credit Rationing in Markets with
Imperfect Information,” American Economic Review, 71(3),
June 1981, pp. 393-410
Akerlof, Lemons.
Credit interlinkages
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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)
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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
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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. 77114.
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Pace will be affected by magnitude of
fiscal stimulation
 Money
to those who are credit constrained
(unemployed)
 Would not work if Ricardian equivalence held
or if redistributions didn’t matter
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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
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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
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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 jobs
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 High
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
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Myopic, short-sighted response
Akin to how Latin America avoided negative impact of oil
price shock—borrowing for consumption
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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
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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 EXPLAIN
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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
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Appraisers owned by originating companies
Rating agencies paid by those producing products
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Intellectual incoherence
 Argued
that they had created new products
that transformed financial markets
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Justified high compensation
 Yet
based risk assessments on data from
before the creation of the new products
 Argued that financial markets were efficient
 Based pricing on spanning theorems
 Yet also argued that they were creating new
products that transformed financial markets
HARD 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
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HARD 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 job
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 Danish
Mortgages
 Variable rate, fixed payment, variable maturity
Regulatory Failure
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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 pooper
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 But
Fed not only failed to dampen party, but
kept it going
 It had alternatives
Going forward
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Actions by market participants generated externalities
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Costs borne by taxpayers
Those who are losing their jobs
 Social problems—millions of Americans losing homes
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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
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Incentives
 Conflicts
of interest
 Longer term
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Behaviors
 Speed
bumps
 Retaining some responsibility for financial
products created
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Accounting
 Reducing
scope for off balance sheet activity
Structures
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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
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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
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 IMF
and Basel failed to provide adequate
regulatory framework
 Notion underlying Basel II that banks could be
relied upon to assess their own risk seems, at
this juncture, absurd
Rich research agenda ahead
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Exploring financial interlinkages
 Bankruptcy cascades
 Optimal network design
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(preventing contagion)
Designing financial instruments that better reflect
information imperfections and systematic
irrationalities
Designing appropriate mix of financial institutions
 Taking into account local
 Need for renegotiation
 Asymmetries
information
of information created by securitization
Rich research agenda ahead
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Macro-economic models that take into
account complexity of financial system
 Including
financial linkages
 Recognizing role of banks
 And the consequences of redistributions
 Information imperfections, bubbles (rational
herding and irrational)
Research and Policy Agenda
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Unfettered financial markets do not work
 But
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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
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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
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Our financial system failed in its core missions—
allocating capital and managing risk
With disastrous economic and social
consequences
 Huge
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disparity between potential and actual GDP
We must do better
And a successful research agenda will help us to
do that