Transcript Economic Theory and the Current Economic Crisis

Economic Theory
and the Current
Economic Crisis
Joseph E. Stiglitz
Stanford University
January 2009
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—


Or a result of Central Bank stepping on brakes too hard


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


Akin in many ways to frequent financial crises in developing
countries
Worse version of S & L crisis

Which led to 1991 recession
America’s crisis has been a global
crisis

Earlier there was a “myth” of decoupling


Unlikely in a world of globalization
Effects spread to Europe




Partly because of major financial losses in Europe—America exported its
toxic mortgages
Partly because Europe made many of same mistakes—America had
exported its business practices and deregulatory philosophy
Partly because of exchange rate adjustments, impact on exports
Effects now spreading to developing countries


Money flowing back to US
Partly because of asymmetric effects of symetric policies—US
guarantees more credit
 Partly because of asymmetric policies—developing countries “forced” to
have pro-cyclical policies
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 selfadjusting
 At
least in the relevant time frame
 Role for government in maintaining economy at full
employment
New Lessons

Insights into macro-economics
 Debate
about source of macro-economic
failures
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)

 These
events are already drawing attention to
Greenwald/Stiglitz/Fisher/Minsky models
Insights into micro-economics
Are markets really as efficient and
innovative as market advocates claim?
 How do we explain these market failures?

 Imperfections
of information?
 Irrationality?
What does traditional finance theory have
to say?
 What advice does economic theory give
about what should be done now?

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
 Imperfect information
 Incomplete markets
 Irrational behavior
 But huge inefficiencies—e.g. tax paradoxes
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


B. Greenwald and J.E. Stiglitz, “Externalities in Economies with
Imperfect Information and Incomplete Markets,” Quarterly
Journal of Economics, Vol. 101, No. 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.
This is a micro-economic
failure leading to a macroeconomic problem

Financial markets are supposed to allocate
capital and manage risk
 Misallocated
capital
 Mismanaged risk

Financial markets are a means to an end, not an
end in themselves
 High
productivity would mean they perform these
tasks at low costs
 We prided ourselves on size of our financial sector
Failures have been frequent

This is just the largest and most recent of
financial crises—and bail-outs
S
&L
 Bail-outs with country-names (Mexico, Brazil, Korea,
Indonesia, Argentina, Thailand, Russia…) were
mostly bail-outs of western lenders, a result of
inadequate assessment of credit worthiness
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Main difference is that consequences were felt in “periphery”
And costs of bail-out was largely borne in periphery
Innovation


Financial markets did not create risk products that would
have enabled individuals to manage the risks which they
faced
Innovations—tax, regulatory, and accounting arbitrage


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”

Actually resisted innovations that would
have made markets work better
 Inflation
indexed bonds
 GDP indexed bonds
 Danish mortgage
 Better auctions of Treasury Bills
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

 Danish
mortgages
 Variable rate, fixed payment, variable maturity
A Plethora of Failures

Bad lending
Beyond people’s ability to pay
 Forcing individual’s to bear unreasonable risks (variable rate
mortgages)
 As bubble got worse, increased loan-to-value ratios
 Loan to value ratios in excess of 100%


Based on presumption that prices would continue to go up
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


But how could they—given what was happening to incomes
No doc loans
Appraisal companies owned by mortgage originators—invitation to fraud
High transactions costs


But that was the source of profit
Borrowers will not well informed, and may not have been able to assess

Regulators (and investors) should have been
suspicious
 Non-recourse
100% mortgages are like an option—
giving away money to low income individuals
 Not usual part of business model
 Were manufacturing “paper” to be sold around world


True business model: “A fool is born every minute”
And globalization had opened up a global market
Securitization

While it enhances opportunities for
diversification, creates new agency
problems (new asymmetries of
information)
 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 ProMarket Intervention, J.A. Roumasset and S. Barr (eds.),
Westview Press, Boulder, 1992, pp. 15-38.
Securitization: further problems

Underestimated correlations, problems of systemic risk, fat-tailed
distributions

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Once in a century events have occurred repeatedly
Underestimated potential consequences of conflicts of interest,
moral hazard problems, perverse incentives and scope for fraud

Appraisers owned by originating companies
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
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Rating agencies paid by those producing products
Underestimated risk of price declines
Problems have occurred repeatedly, and were predicted
Underestimated problems arising from necessity of renegotiation

Problems were apparent
But this does not fully
explain what went wrong

Hard to reconcile behavior with rationality
 Or
even rational herding behavior
 Bad lending practices have been obvious to both
borrower and lender, to those packaging securities
and to those buying the packages

But those in financial market were supposed to be financially
sophisticated
Models used by banks and rating
agencies flawed and obviously so
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Seemed to believe in financial alchemy—that they could
convert F rated sub prime mortgages into A rated
securities
Underestimated correlations
Underestimated systemic risks
Once in a lifetime events happened every ten years
 Should have used fat tailed distributions rather than
lognormal distributions
 But there already were several instances of failures
from using these models—financial markets didn’t
learn
Intellectual incoherence
Argued 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 efficient
 Based pricing on spanning theorems
 Yet also argued that they were creating new products
that transformed financial markets
Incentives

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At root of problem is incentives--Incentives matter
But incentives in financial markets were distorted

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Focus only on short term profits
Asymmetric rewards—20% of gains, none of losses
Designed to encourage gambling (excessive risk taking)
Succeeded
Reliance on non-transparent stock options encouraged distorted
accounting
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Easier to increase reported returns than to provide better products
Opposed reforms for improved accounting
Rating agencies paid by those that they rate
Explaining distorted incentives

Problems in corporate governance
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Not addressed in Sarbanes Oxley
Moral hazard problem created by history of bail-outs
Exacerbated by the fact that they had become too big to
fail—and knew it
But again—hard to reconcile with “rational” markets: why
didn’t investors recognize the nature of perverse
incentives and the consequences
Derivatives

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Useful way of managing risk
But were used to create risk—gambling
 Gambling markets are zero sum markets
 Why did each think that they were smarter
than
others—or was it just a result of perverse incentives

Failed to net out
 Failed to recognize importance of counterparty
 Even as they were betting on the failures of
risk
counterparties—another example of intellectual
incoherence
Regulatory failure

Whenever there are externalities (costs borne by
others—including the costs of bail-outs, implicit
insurance) there is a need for regulation

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Financial sector failure gives rise to massive market failure
But deregulatory philosophy said markets could take care of
themselves

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Ignored history
Ignored theory of market failure—externalities
Problem with both regulations, regulatory institutions,
and regulators

Hard to get good regulation from a regulator who does not
believe in regulation

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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

 But
Fed not only failed to dampen party but
also kept it going
 It had alternatives
Three critical ingredients
Bad lending/banking/risk management
 Flawed regulations
 Loose monetary policies
Mixture was explosive

Standard models and policy
prescriptions used by Central Bank
did not anticipate problem


Indeed, they made it worse
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 bubble—yet, curiously, denied
existence of bubble (a little froth)
 Econometric
Models to predict economic
vulnerability

J.E. Stiglitz and J. Furman, “Economic Crises:
Evidence and Insights from East Asia,” 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
 And
can’t take into account interactions arising from
banks’ simultaneously following similar policies

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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 at 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
 Economics

professor shares blame
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 happene
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 affected also 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

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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 underlies 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 stimulation
 Money
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?
Paulson’s original plan—cash for
trash-- badly flawed



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Based on trickle down economics—throwing enough
money at Wall Street will trickle down to rest of economy
Like mass transfusion—while patient is dying from
internal bleeding
Does nothing to stop hemorrhaging
Buying hundreds of thousands of toxic mortgages and
derivatives based on them is complex—and because of
lemons problem taxpayer would almost surely overpay
If we don’t overpay, won’t repair hole in balance sheet
Alternative: Equity injection
 Preferred shares with warrants
 Downside protection, upside potential

Is it enough?


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We don’t know—banks too non-transparent
But what would have been enough one month ago is not enough
today—and it is increasing apparent that it is not enough
Bail-outs getting larger and larger—to little effect
But exposing taxpayers to increasing risk
Massive blood transfusion to a patient suffering from internal
hemorrhaging


We aren’t doing anything significant about foreclosure problems
We aren’t doing anything to prevent further deterioration of
economy

Will it ensure resumption of lending?
not—hasn’t worked so far
 Didn’t stop banks from distributing money to
shareholders, even as government was
pumping money in (contrast with U.K.)
 Probably

But hasn’t been working well in U.K.
 Didn’t
provide adequate oversight (contrast
with U.K.)

Will it restore confidence?
 Probably
only to a limited extent—not worked so far
 No change in those in charge (contrast to U.K.), no
sense of accountability
 No change in regulations and regulatory structures
 Increase in guarantees helpful, but still insufficient

Did the taxpayer get a good deal?
 One
question for which there is a clear
answer—taxpayers got a raw deal
Prices of shares after announcement
 Pricing of preferred shares, terms
 Contrast with Buffett, U.K.

 Important:
growing national debt will make
taking appropriate actions more and more
difficult
What should be done

Need a bail-out plan that focuses on “bang for the buck,” ensuring
taxpayer gets maximum return, does not exacerbate long run
problems



Consolidation increasing problems of “too big to fail”
Bail-outs increasing moral hazard problem
Nationalization (“conservatorship”) may be only solution


Current strategy has too many conflicts of interest
Banks maximizing shareholder value (other than government) even
more dissonant with social interests
 Those in sector have not demonstrated impressive credentials in risk
management and resource allocation
 Further advantages—netting out claims
 Swedish model—worked reasonably well
Doing something about
foreclosures

Helping people stay in their homes
 Already
3 million foreclosures, 2 million more
expected in next year
 Converting tax deduction to tax credit
 Bankruptcy reform—homeowners’ chapter 11
 Direct lending to homeowners at government’s lower
cost of capital and better enforcement mechanisms


Combined with conversion to recourse loans
And major haircut for banks—reducing loan amount to 90%
of house value
Stimulus

Even with program, economy is headed for recession


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What is needed

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
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Credit contraction
Worsening of balance sheets
Cutbacks in state and local spending
Expanded unemployment benefits
Aid to states and localities
More investment
Given high national debt, important to have large bang
for buck, make sure that as we increase liabilities, we
are increasing assets
America does not need to stimulate consumption


Problem has been too much consumption
Simply postpones day of reckoning
Result of flawed bail-out and flawed
and inadequate stimulus

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
Economic downturn will be longer and deeper than it
otherwise would have been
And America’s national debt will be much larger than it
otherwise would have been
Both will have global consequences
Will U.S. be able to have the size of the stimulus we
need, for as long as we need it?
Will we emerge from this crisis with a robust economy, or
into a Japanese style malaise?
We have not yet begun to address the more fundamental
underlying macro-economic problems
The Fundamental Macro Problems

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 jobs

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


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,
2008
Going forward

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
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

Incentives
 Conflicts of interest
 Longer term
 Asymmetries give rise
 Stock options

to excessive risk taking
Behaviors
 Speed bumps
 Retaining 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
dealings

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 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

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 linkages
 Recognizing role of banks
 And the consequences of redistributions
 Information imperfections, bubbles (rational
herding and irrational)
Research and Policy Agenda

Unfettered financial markets do not work
 But

Markets are not self-adjusting
 At

regulation and regulatory institutions failed
least in the relevant time frame
Darwinian natural selection may not work
 Like
Gresham’s law—bad money drives out good
 Reckless firms forced more conservative firms to
follow investment strategies
 More prudent firms might have done better in long
run—but couldn’t survive to take advantage of that
long run

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