Economic Theory and the Current Economic Crisis

Economic Theory and the Current Economic Crisis Joseph E. Stiglitz Manchester October 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 led 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

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

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

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 • Actually resisted innovations that would have made markets work better • Inflation indexed bonds • GDP indexed bonds • Danish mortgage • Better mortgages that would have managed risk better • Better auctions of Treasury Bills

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 • 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

Mismatch between private rewards and social returns (which may be negative) • Social returns may have been negative • Yet as a sector and as individuals they were generously compensated • Some 40% of corporate profits • With predictable consequences—behavior designed to enhance private returns, not social benefits

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, 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.

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?

Models used by banks and rating agencies flawed and obviously so • 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

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 this

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 • 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 modelscentered 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 • 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 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 plan 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 will overpay • If we don’t overpay, won’t repair hole in balance sheet

What should have been done • Equity injection • Preferred shares with warrants • Downside protection, upside potential • 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 • America does not need to stimulate consumption • Problem has been too much consumption • Simply postpones day of reckoning

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, 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 also 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 • 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 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 • 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

Economic Theory and the Current Economic Crisis