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— • 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 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 • 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 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 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 • 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’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? • 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? • Probably 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.) • 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 • 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 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

Economic Theory and the Current Economic Crisis