INFORMATION AND CAPITAL MARKETS: LESSONS FROM RECENT THEORY AND EXPERIENCES

INFORMATION AND CAPITAL MARKETS:LESSONS FROM RECENT THEORY AND EXPERIENCES Joseph E. Stiglitz Oscar di Bilancio Lecture December 1, 2004 Milan

THE IMPORTANCE OF CAPITAL MARKETS • CAPITAL MARKETS ARE LIKE THE BRAIN OF THE ECONOMY • THEY GATHER, PROCESS, AND DISSEMINATE INFORMATION • ON THE BASIS OF WHICH SCARCE CAPITAL IS ALLOCATED • HOW WELL THEY PERFORM THEIR TASK HAS MUCH TO DO WITH HOW WELL THE ECONOMY PERFORMS OVERALL

ADAM SMITH’S INVISIBLE HAND • MOST IMPORTANT RESULT IN MODERN ECONOMICS • Formal proof not achieved until mid twentieth century by Ken Arrow of Stanford and Gerard Debreu of Berkely • HOLDS THAT COMPETITIVE MARKETS ALLOCATE RESOURCES EFFICIENTLY • Though does not in general result in social justice or even an acceptable distribution of income • THE PRICE SYSTEM AND THE PURSUIT OF SELF INTEREST LEADS, AS IF BY AN INVISIBLE HAND, TO ECONOMIC EFFICIENCY

AN IMPORTANT WARNING • GREENWALD AND STIGLITZ SHOWED IN MID 80S THAT WHEN INFORMATION AND MARKETS ARE IMPERFECT—THAT IS ALWAYS--ADAM SMITH’S INVISIBLE HAND THEOREM IS NOT TRUE • THE REASON THAT THE INVISIBLE HAND OFTEN SEEMS INVISIBLE IS THAT IT’S NOT THERE • ESPECIALLY IMPORTANT IN THINKING ABOUT CAPITAL MARKETS—WHICH CENTER AROUND INFORMATION

Hint of future argument: greed (extreme form of pursuit of self interest) so evident in U.S. during Roaring 90s, did not lead to economic efficiency. • It lead to bubble that burst. • During Bubble massive misallocation of resources • After burst, massive underutilization of resources—over last four years gap between economy’s potential and actual output (cumulatively) around $1.7 trillion • Problems were pervasive • Not just a question of a few rotten apples • Have to look for systemic origins • No reason to believe that generation of the 90s more immoral than earlier generations • Have to look for changes in incentives • Every person has his price • In 90’s, more people found that price

“Chicago Perfect Markets School”: • CAPITAL MARKETS ARE EFFICIENT • PERFECTLY TRANSMITTING ALL INFORMATION • IMPORTANT IMPLICATIONS • Buy indexed funds • Can’t beat the market

FIRST CHALLENGE:Imperfect Information School • GROSSMAN STIGLITZ –IMPOSSIBILITY OF INFORMATIONALLY EFFICIENT MARKETS • IF MARKETS WERE INFORMATIONALLY EFFICIENT, NO ONE WOULD HAVE ANY INCENTIVE TO GATHER INFORMATION • ONLY INFORMATION IN THE MARKET WOULD BE ‘FREE’ INFORMATION • MARKETS ARE CHARACTERIZED BY AN EQUILIBRIUM LEVEL OF DISEQUILIBRIUM

CHALLENGE IIIrrationality • MARKETS CHARACTERIZED BY IRRATIONAL EXUBERANCE AND PESSIMISM • REFLECTED IN EXCESS VOLATILITY • Could any “news” justify wiping out 25% of capital value of stock market in 1997, or even larger fraction of tech stocks in 2000? • LARGE NUMBER OF STOCK MARKET ANAMOLIES • January effect • Often disappear when brought to light

EXPLANATIONS IBehavioral Economics • Kanehman (Nobel Prize 2002) and Tvsersky recognized that there were systematic ways in which individuals behaved that were hard to reconcile with rationality • Anchoring • Difficulties in making probabilistic judgments, especially about rare events • Excessive myopia • Herd behavior • Long recognized in standard Keynesian macro-economics • “animal spirits” • Money illusion

EXPLANATION IIInformation Economics • FOR PRICE SYSTEM TO WORK WELL, PRICES MUST BE BASED ON GOOD (UNDISTORTED INFORMATION) • IN 90’S INCENTIVES WERE IN PLACE TO PRODUCE DISTORTED INFORMATION

STOCK OPTIONS • SOLD AS METHOD OF PROVIDING STRONG INCENTIVES • IN FACT, THERE WERE BETTER WAYS OF PROVIDING OF INCENTIVES (RELATIVE PERFORMANCE) • LESS DEPENDENT ON VAGARIES OF STOCK MARKET • PROVIDING STRONGER INCENTIVES WITH LESS RISK • IN FACT, ACTUALLY PROVIDED WEAK INCENTIVES • PAY REMAINED HIGH IN 2000, 2001 EVEN WHEN STOCK PRICE WENT DOWN

STOCK OPTIONS • ACCOUNTING FRAMEWORKS MADE IT DIFFICULT TO ASCERTAIN EXTENT TO WHICH SHARE VALUE WAS DILUTED—COST TO SHAREHOLDER • EXECUTIVES HAD INCENTIVE TO PROVIDE INFORMATION WHICH LED TO INCREASE IN STOCK PRICE (IN SHORT RUN) • PROBLEM RECOGNIZED IN EARLY 90S, BUT TO MANY WERE BENEFITING TO MAKE CHANGE • CONFLICT OF INTEREST—BETWEEN SERVING INTERESTS OF SHAREHOLDERS AND THEIR OWN INTERESTS

ACCOUNTANTS • WERE SUPPOSED TO PROVIDE CHECK ON CORPORATIONS • BUT, HIRED BY CEO’S, AND WITH MOST OF INCOME DERIVED FROM CONSULTING, THEIR INCENTIVE WAS TO PLEASE CEO. • ANOTHER CONFLICT OF INTEREST • RECOGNIZED IN MID 90S • BUT THOSE WHO BENEFITED RESISTED CHANGE

BANKS • ANALYSTS • PAID BY INVESTMENT BANKS • BUT SUPPOSED TO PROVIDE ACCURATE INFORMATION • OBVIOUS POTENTIAL CONFLICT OF INTEREST • PLAYED OUT IN 90S • IPO discounts made it worse • GLASS-STEAGALL • SEPARATION OF COMMERCIAL AND INVESTMENT BANKS • TO AVOID CONFLICTS OF INTEREST • CREATED CHINESE WALLS • BUT WHAT WAS ADVANTAGE OF MERGER WITH CHINESE WALLS • IN FACT, CHINESE WALLS WERE NOT VERY HIGH • FEARS OF CONFLICT REALIZED

SELF REGULATION • NEW YORK STOCK EXCHANGE • OBVIOUS POTENTIAL FOR CONFLICT OF INTEREST WITH SALARY OF SELF-REGULATOR SET BY THOSE HE REGULATES • EXPOSED BY GRASSO ABUSES

BASIC LESSONS • INCENTIVES MATTER • BUT IF THERE ARE THE WRONG INCENTIVES, MARKTS WILL NOT WORK WELL • CAPITAL MARKETS ARE NOT INFORMATIONALLY EFFICIENT • BUT PROBLEMS ARE EXACERBATED IF THERE ARE NOT IN PLACE GOOD ACCOUNTING STANDARDS • IF THERE ARE CONFLICTS OF INTEREST, LEADING TO BAD INFORMATION AND THE FAILURE OF SYSTEM OF CHECKS AND BALANCES • ACCOUNTANTS AND BANKS ARE SUPPOSED TO PROVIDE SOME OF THE NECESSARY CHECKS AND BALANCES • BUT THEY TOO HAD THE WRONG INCENTIVES • A FAILURE OF CORPORATE GOVERNANCE • WITH COSTS TO SHAREHOLDERS • AND TO OTHER STAKEHOLDERS

CONCLUSIONS • MARKETS ARE AT THE CENTER OF A SUCCESSFUL ECONOMY • BUT SUCCESS ALSO REQUIRES GETTING RIGHT THE BALANCE BETWEEN GOVERNMENT AND MARKETS • INCLUDING REGULATORY FRAMEWORKS TO AVOID CONFLICTS OF INTEREST • ADAM SMITH WAS WRONG • BUT WITH APPROPRIATE ROLE FOR GOVERNMENT, MARKETS ARE MORE LIKELY TO LEAD TO ECONOMIC EFFICIENCY

INFORMATION AND CAPITAL MARKETS: LESSONS FROM RECENT THEORY AND EXPERIENCES