Economic Theory and the Current Economic CrisisJoseph 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—

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 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 self-adjusting 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

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 macro-

economic 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

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 bondsGDP indexed bondsDanish mortgageBetter 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 jobDanish mortgagesVariable 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 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 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.

Securitization: further problems

Underestimated correlations, problems of systemic risk, fat-tailed distributions 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

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

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

At root of problem is incentives--Incentives matter But incentives in financial markets were distorted

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 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 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

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 risk Even as they were betting on the failures of

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 Financial sector failure gives rise to massive market failure But deregulatory philosophy said markets could take care of

themselves 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

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

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 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

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 inflationEconomics 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

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 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

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 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 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?

Paulson’s original plan—cash for trash-- badly flawed

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?Is it enough? We don’t know—banks too non-transparentWe don’t know—banks too non-transparent But what would have been enough one month ago is not enough But what would have been enough one month ago is not enough

today—and it is increasing apparent that it is not enoughtoday—and it is increasing apparent that it is not enough Bail-outs getting larger and larger—to little effectBail-outs getting larger and larger—to little effect But exposing taxpayers to increasing riskBut exposing taxpayers to increasing risk Massive blood transfusion to a patient suffering from internal Massive blood transfusion to a patient suffering from internal

hemorrhaging hemorrhaging We aren’t doing anything significant about foreclosure problemsWe aren’t doing anything significant about foreclosure problems We aren’t doing anything to prevent further deterioration of economyWe aren’t doing anything to prevent further deterioration of economy

Will it ensure resumption of lending?Will it ensure resumption of lending?Probably not—hasn’t worked so farProbably not—hasn’t worked so farDidn’t stop banks from distributing money to Didn’t stop banks from distributing money to

shareholders, even as government was shareholders, even as government was pumping money in (contrast with U.K.)pumping money in (contrast with U.K.)

But hasn’t been working well in U.K.But hasn’t been working well in U.K.

Didn’t provide adequate oversight (contrast Didn’t provide adequate oversight (contrast with U.K.)with U.K.)

Will it restore confidence?Will it restore confidence? Probably only to a limited extent—not worked so farProbably only to a limited extent—not worked so far No change in those in charge (contrast to U.K.), no No change in those in charge (contrast to U.K.), no

sense of accountabilitysense of accountability No change in regulations and regulatory structuresNo change in regulations and regulatory structures Increase in guarantees helpful, but still insufficientIncrease in guarantees helpful, but still insufficient

Did the taxpayer get a good deal?Did the taxpayer get a good deal?One question for which there is a clear One question for which there is a clear

answer—taxpayers got a raw dealanswer—taxpayers got a raw deal Prices of shares after announcementPrices of shares after announcement Pricing of preferred shares, termsPricing of preferred shares, terms Contrast with Buffett, U.K.Contrast with Buffett, U.K.

Important: growing national debt will make Important: growing national debt will make taking appropriate actions more and more taking appropriate actions more and more difficultdifficult

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 Credit contraction Worsening of balance sheets Cutbacks in state and local spending

What is needed 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 Economic downturn will be longer and deeper than it Economic downturn will be longer and deeper than it

otherwise would have beenotherwise would have been And America’s national debt will be much larger than it And America’s national debt will be much larger than it

otherwise would have beenotherwise would have been Both will have global consequencesBoth will have global consequences Will U.S. be able to have the size of the stimulus we Will U.S. be able to have the size of the stimulus we

need, for as long as we need it?need, for as long as we need it? Will we emerge from this crisis with a robust economy, or Will we emerge from this crisis with a robust economy, or

into a Japanese style malaise?into a Japanese style malaise? We have not yet begun to address the more fundamental We have not yet begun to address the more fundamental

underlying macro-economic problemsunderlying 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

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 to excessive risk taking Stock options

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 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 Markets are not self-adjusting

At 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