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 • 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 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 • 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 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

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 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?

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 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: 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 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 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

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

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 • Danish Mortgages • Variable 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 pooper • But 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 • Incentives • Conflicts of interest • Longer term • 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 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 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 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

Economic Theory and the Current Economic Crisis