Rethinking Macroeconomics

8/6/2019 Rethinking Macroeconomics

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RETHINKINGMACROECONOMICS:WHATWENTWRONGANDHOWTOFIXIT

JosephE.Stiglitz

AdamSmithLecture

EuropeanEconomicAssociationGlasgow

August24,2010


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Outline

Thefailuresoftheexistingparadigm

Andthepolicyframeworksbasedonthem

Explainingthefailures: keyassumptions,key

omissionsSomemethodologicalremarks

Keyunansweredquestions

Fivehypotheses

Newframeworks/models


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GeneralConsensus:

StandardeconomicmodelsdidnotpredictthecrisisAndpredictionisthetestofanyscience

Worse: Mostofthestandardmodels(includingthoseusedbypolicymakers)arguedthatbubbles

couldnt exist,becausemarketsareefficientandstableManyofthestandardmodelsassumedtherecouldbe

nounemployment(labormarketsclear)

Iftherewasunemployment,itwasbecauseofwagerigidities Implyingcountrieswithmoreflexiblelabormarketswould

havelowerunemployment


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SixFlawsinPolicyFramework

Policymakingframeworksbasedonthatmodel(or

conventionalwisdom)wereequallyflawed Maintainingpricestabilityisnecessaryand

almostsufficientforgrowthandstabilityItisnottheroleoftheFedtoensurestabilityofasset

prices

Markets,bythemselves,areefficient,self

correctingCanthereforerelyonselfregulation

Inparticular,therecannotbebubblesJustalittlefrothinthehousingmarket


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ConventionalPolicyWisdom

Eveniftheremightbeabubble,couldntbesure,untilafteritbreaks

Andinanycase,theinterestrateisabluntinstrument

Usingittobreakbubblewilldistorteconomyandhaveotheradversesideeffects

Lessexpensivetocleanupaproblemafterbubblebreaks

IMPLICATION:

DO

NOTHINGExpectedbenefitsmall,expectedcostlarge

EACHOFTHESEPROPOSITIONSISFLAWED


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1.Inflationtargeting

Distortionsfromrelativecommoditypricesbeingoutofequilibriumasaresultofinflationaresecondorder

relativetolossesfromfinancialsectordistortions Bothbeforethecrisis,evenmore,afterthebubblebroke

Ensuringlowinflationdoesnotsufficetoensurehighand

stablegrowth Moregenerally,nogeneraltheoremthatoptimal

responsetoaperturbationleadingtomoreinflationistoraiseinterestrate

Dependsonsourceofdisturbance

Inflationtargetingrisksshiftingattentionawayfromfirstorderconcerns


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2. Marketsareneitherefficientnor

selfcorrecting Generaltheorem: wheneverinformationisimperfector

riskmarketsincomplete(thatis,always)marketsarenotconstrained

Pareto

efficient

(Greenwald

Stiglitz) Pervasiveexternalities

Pervasiveagency

problems

Manifestinfinancialsector(e.g.intheirincentivestructure)

Greenspan

should

not

have

been

surprised

at

risksthey

had

incentivetoundertakeexcessiverisk Bothattheindividuallevel(agencyproblems) Andorganizational(toobigtofail) Problemsoftoobigtofailbankshadgrownmarkedlyworsein

previousdecadeasaresultofrepealofGlassSteagall Systemicconsequences(whichmarketparticipantswillnot

takeintoaccount)arethereasonwehaveregulation Especiallysignificantwhengovernmentprovides(implicitor

explicit)insurance


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3. Therecannotbebubbles..

Bubbleshavemarkedcapitalismsincethe

beginning Bubblesareevenconsistentwithmodelsof

rationalexpectations

(Allen,

Morris,

and

Postlewaite 1993)andrationalarbitrage(Abreu

andBrunnermeier

2003).

Collateralbasedcreditsystemsareespecially

pronetobubbles


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4. Cantbesure

Allpolicyismadeinthecontextofuncertainty

Ashousingpricescontinuedtoincrease eventhoughrealincomesofmostAmericanswere

decliningit

was

increasingly

likely

that

therewasabubble


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5. Wehadnoinstruments

Wehadinstruments Congresshadgiventhemadditionalauthorityin1994

Ifneededmoreauthority,could/shouldhavegonetoCongresstoaskforit Couldhaveusedregulations(loantovalueratios)todampen

bubble Hadbeenbrieflymentionedduringtechbubble

Ideologicalcommitmentnottointerveneinthemarket Butsettinginterestratesisaninterventioninthemarket

Generalconsensusontheneedforsuchintervention Ramseytheorem: singleinterventioningeneralnotoptimal Tinbergen: withmultipleobjectivesneedmultipleinstruments

Evenwithsingleobjective,withriskpreferabletousemultiple

instruments Theyhadmultipleinstruments


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6. Lessexpensivetocleanupthe

mess Fewwouldagreewiththattoday

Lossbeforethebubblebrokeinhundredsofbillions

Lossafterthebubbleintrillions


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Whatwentwrong? Whydidthe

modelsfail? Allmodelsrepresentsimplification

Keyissue: whatwerethecriticalomissionsofthestandardmodels? Whatwerethemostmisleadingassumptionsofthemodels? Answerdependspartlyonthequestionsbeingasked

Widevarietyofmodelsemployed,soanybriefdiscussionhastoentailsomecaricature

Dynamic,stochastic,generalequilibriummodels

focusedon

three

key

elements

Macrodynamicscrucial

Uncertaintyiscentral

Andpartialequilibriummodelsarelikelytobemisleading


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KeyProblem

Notwithdynamicstochasticgeneralequilibrium analysisbutspecificassumptionsNeedtosimplifysomewhereProblemisthatStandardModelsmadewrong

simplifications Inrepresentativeagentmodels,thereisnoscopeforinformation

asymmetries(exceptwithacuteschizophrenia)

Inrepresentativeagentmodels,thereisnoscopeforredistributiveeffects

Inrepresentativeagentmodels,thereisnoscopeforafinancial

sector Whoislendingtowhom?Andwhatdoesbankruptcymean?


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Argumentsforsimplifications

uncompelling Needtoreconcilemacro withmicroeconomics,deriveaggregaterelationsfrommicrofoundations

Butstandardmicrotheoryputsfewrestrictionsonaggregatedemandfunctions(Mantel,Sonnenschein)

Restrictionsresultfromassumingrepresentativeagent

Hardtoreconcilemacrobehaviorwithreasonablespecifications(e.g.laborsupply,riskaversion)

Importanttoderivemacrobehaviorfromright

micro

foundations Consistentwithactualbehavior

Takingintoaccountinformationasymmetries,imperfections

Goingforward: exploreimplicationsofdifferentsimplifications


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RecentProgress

RecentDSGEmodelshavegonebeyond

representativeagentmodelsand

incorporatedcapitalmarketimperfections

Questionremains: Havetheyincorporatedkey

sourcesofheterogeneityandcapitalmarketimperfections

Lifecyclecentraltobehaviormodelswithinfinitely

livedindividualshavenolifecycle

Factordistributionkeytoincome/wealthdistribution


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Equityandcreditconstraintsbothplayakeyrole

Asdodifferencesbetweenbankandshadowbanking

system

Somenotablesuccesses(Korinek,JeaneKorinek)


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AskingtheRightQuestions

Testofagoodmacromodelisnotwhetherit

predictsa

little

better

in

normal times,butwhetheritanticipatesabnormaltimesand

describeswhathappensthen

Blackholesnormally dontoccurStandardeconomicmethodologywouldthereforediscardphysicsmodelsinwhichtheyplayacentral

roleRecessionisapathologythroughwhichwecancome

tounderstandbetterthefunctioningofanormaleconomy


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Majorpuzzle: Fastdeclines,slow

recoveries1.

Intheabsenceofwar,statevariables(capitalstocks)changeslowly. Whythencanthestateoftheeconomychangeso

quickly? Importanceofexpectations

Butthatjustpushesthequestionbackfurther: whyshouldexpectationschangesodramatically,withoutanybignews?

EspeciallywithrationalindividualsformingBayesianexpectations

PuzzleofOctober,1987HowcouldaquarterofthePDVofthecapitalstockdisappearovernight?

Discretegovernmentpolicychanges Removingimplicitgovernmentguarantee(adiscreteaction)

Dramaticincreasesininterestrates(EastAsia)

Butthesediscretepolicychangesusuallyarearesultofsudden

changes

instateofeconomy Thoughintendedtodampentheeffects,theysometimeshaveoppositeeffectof

amplification

L C St t E


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LargeC anges nStateo EconomyfromSmallChangesinState

Variables Consequenceofimportantnonlinearities ineconomicstructure

Familiarfromoldnonlinearbusinesscyclemodels

(Goodwin)

Individualsfacingcreditconstraints

LeadingtoendofbubbleThoughwithindividualheterogeneity,eventhen

therecan/shouldbesomesmoothing


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FastDeclines

Whatevercause,changesinexpectationscangiverise

tolargechangesin(asset)prices

Andwhatevercause,effectsoflargechangesinprices

canbeamplified

byeconomicstructure(withfollow

oneffects

that

are

prolonged)

Understandingamplificationshouldbeoneofkey

objectivesofresearch


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Amplification

Financialaccelerator(derivedfromcapitalmarketimperfectionsrelatedtoinformationasymmetries)

(GreenwaldStiglitz,1993,BernankeGertler,1995)

Trendreinforcement

effectsinstochasticmodels

(Battiston

etal2010)

Newuncertainties: Largechangesinpricesleadtolargeincreasesin

uncertaintiesaboutnetworthofdifferentmarket

participants

abilitytofulfillcontracts

Changesinriskperceptions(notjustmeans)matter

Crisisshowedthatprevailingbeliefsmightnotbecorrect

Anddramaticallyincreaseduncertainties


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AmplificationsImplyFastDeclines

NewInformationimperfections Anylargechangeinpricescangiverisetoinformation

asymmetries/imperfectionswithrealconsequences Indeed,evenasmallchangeinpricescanhavefirstordereffectsonwelfare(andbehavior) Unlikestandardmodel,wheremarketequilibriumisPO(envelopetheorem

Redistributions Withlargepricechanges,largegamblestherecanbefast

redistributions(balancesheeteffects)withlargerealconsequences

Especiallyiftherearelargedifferencesamongindividuals/firms

Withsomefacingconstraints,othersnot


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Control

Whoexercisescontrolmatters(unlikestandardneoclassical

model) Canbediscretechangesinbehavior

Withbankruptcyandredistributions,therecanbequick

changesin

control


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2. SlowRecovery

Therewerelargelossesassociatedwithmisallocationofcapitalbeforethebubblebroke. Itiseasytoconstruct

modelsofbubbles. Butmostofthelossesoccurafterthebubblebreaks,inthepersistentgapbetweenactualandpotentialoutput Standardtheorypredictsarelativelyquickrecovery,asthe

economyadjuststonewrealityNewequilibriumassociatedwithnewstatevariables(treating

expectationsasastatevariable)

Andsometimesthatisthecase(Vshapedrecovery)

ButsometimestherecoveryisveryslowPersistenceofeffectsofshocks

(partiallyexplainedbyinformation/creditmarketimperfections(GreenwaldStiglitz))rebuildingbalancesheetstakestime


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FightoverWhoBearsLosses

Afterbubblebreaks,claimsonassetsexceedvalueofassets

Someonehastobearlosses;fightisoverwhobearslosses

Fightoverwhobearslossesandresultingambiguityinlongtermownershipcontributestoslowrecovery

Standardresultintheoryofbargainingwithasymmetricinformation

Threewaysofresolving Inflation

Bankruptcy/assetrestructuring

Muddlingthrough(nontransparentaccountingavoidingbankrecapitalization,slowforeclosure)

Americahaschosenthirdcourse


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NewFrameworks

Frameworksfocusingon

1. Risk2.

Informationimperfections

3. Structuraltransformation4. Stability


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andFourHypotheses

HypothesisA: Therehavebeenlarge(andoftenadverse)changesintheeconomysriskproperties,inspiteofsupposedimprovementsinmarkets

HypothesisB: Movingfrombanks

tomarketspredictablyledtodeteriorationinqualityofinformation

HypothesisC: structuraltransformationsmaybeassociatedwithextendedperiodsofunderutilizationofresources

HypothesisD: Especiallywithinformationimperfections,marketadjustmentstoaperturbationfromequilibriummaybe(locally) destablizing


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UnderlyingTheorem

Marketsarenotingeneral(constrained)

ParetoefficientOnceasymmetriesininformation/imperfections

ofriskmarketsaretakenintoaccount

Noraretheystable

Inresponsetosmallperturbations

Andevenlesssoinresponsetolargedisturbances

associatedwithstructuraltransformation


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Insufficient attention to architecture


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Insufficientattentionto architecture

ofrisk

Theorywasthatdiversificationwouldleadtolowerrisk,morestableeconomy

Didnthappen:

where

did

theory

go

wrong?

Mathematics: Madeassumptionsinwhichspreadingrisknecessarilyincreases

expectedutility Withnonconvexities(e.g.associatedwithbankruptcy,R&D)itcan

leadtolowereconomicperformance Twosidesreflectedinstandarddebate

Beforecrisisadvantagesofglobalization Aftercrisesrisksofcontagion Bank bailoutseparateoutgoodloansfrombad(unmixing)

Standardmodelsonlyreflectformer,notlatter Shouldreflectboth Optimalelectricgrids Circuitbreakers


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NewResearch

Recentresearchreflectingboth

FullintegrationmayneverbedesirableStiglitz,AER 2010,JournalofGlobalizationandDevelopment,2010:Inlifecyclemodel,capitalmarketliberalizationincreasesconsumptionvolatilityandmaylowerexpectedutility

Stiglitz,OxfordReviewofEconomicPolicyOxfordReviewofEconomicPolicy,2004


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NewResearch

Showinghoweconomicstructures,including

interlinkages,interdependencies

can

affect

systemicrisk

Privatelyprofitableinterlinkages

(contracts)are

not,ingeneral,constrainedParetoefficient AnothercorollaryofGreenwaldStiglitz

1986

Interconnectivitycanhelpabsorbsmallshocksbut

exacerbatelargeshocks,canbebeneficialingoodtimesbutdetrimentalinbadtimes


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Furtherresults: DesignMatters Poorlydesignedstructurescanincreasesrisk

ofbankruptcycascades

Greenwald&Stiglitz (2003),AllenGale(2000) Hubsystemsmaybemorevulnerabletosystemicriskassociatedwithcertaintypesofshocks

Many

financial

systems

have

concentrated

nodes Circuitbreakerscanaffectsystemicstability

Realproblemincontagionisnotthose

countriessufferingfromcrisis(dealingwiththatisakintosymptomaticrelief)butthehubsintheadvancedindustrialcountry

Haldane (2009),Haldane &May(2010),Battiston etal(2007,2009),Gallegati etal(2006,2009),


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Canbeaffectedbypolicyframeworks

Bankruptcy

law(indenturedservitude)

Lendersmaytakelesscareingivingloans

(Miller/Stiglitz,1999,2010) Morecompetitivebankingsystemlowersfranchisevalue

Mayleadtoexcessiverisktaking (Hellman,Murdock,andStiglitz,2000)

Excessiverelianceoncapitaladequacystandardscanleadtoincreasedamplification(unlesscyclicallyadjusted) Capitalmarketliberalization

Flowsintoandoutofcountrycanincreaseriskofinstability

Financialmarketliberalization Mayhaveplayedaroleinspreadingcrisis InmanyLDCs,liberalizationhasbeenassociatedwithless

lendingtoSMEs


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HypothesisB: Movingfrombanks

tomarketspredictablyledtodeteriorationinqualityofinformation

InherentinformationprobleminmarketsThepublicgoodisapublicgood

Goodinformation/managementisapublicgood

Shadowbankingsystemnotasubstituteforbankingsystem

Leadingto

deterioration

in

quality

of

lending

Inherentproblemsinratingagencies Butalsoincreasedproblemsassociatedwithrenegotiationof

contracts(Increasinglitigationrisk)

Improvingmarkets

mayleadtolowerinformationcontentin

markets ExtensionofGrossmanStiglitz

Problemsposedbyflashtrading? (Inzerosumgame,moreinformationrentsappropriatedbythoselookingatbehaviorofthosewhogatherandprocessinformation)


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Again: Marketequilibriumisnotin

generalefficientDerivativesmarketanexampleLargefractionofmarketoverthecounter,nontransparent

Hugeexposuresin

billionsPreviousdiscussionemphasizedrisksposedbyinterconnectivity

Furtherproblemsposedbylackoftransparencyofoverthecountermarket

Underminingabilitytohavemarketdiscipline Marketcouldntassessriskstowhichfirmwasexposed Impededbasicnotionsofdecentralizibility

Neededtoknowriskpositionofcounterparties,inaninfiniteweb

Explaininglackoftransparency: Ensuringthatthosewhogatheredinformationgotinformation

rents? Exploitationofmarketignorance? Corruption(asinIPOscandalsinUSearlierindecade)?


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3. StructuralTransformation

GreatDepressionwasaperiodofstructuraltransformationmovefromagriculturaltoindustry;GreatRecessionisanotherperiodofstructuraltransformation(frommanufacturingto

servicesector,

induced

by

productivity

increases

andchangesincomparativeadvantagebroughtonbyglobalization)

Rationalexpectationsmodelsprovidelittleinsightsinthesesituations

Periodsofhighuncertainty,information

imperfections


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HypothesisC: structuraltransformationsmaybeassociatedwithextendedperiodsofunderutilizationofresources

Withelasticityofdemandlessthanunity,sectorwithhighproductivityhasdecliningincome

Theremaybehighcapitalcosts(includingindividual

specificnoncollateralizable investments)associatedwithtransitionbutwithdecliningincomes,itmaybeimpossibletofinancetransitionprivately

Capital

market

imperfections

related

to

information

asymmetries Decliningincomesintrapped

highproductivitysectorhas

adverseeffectonothersectors


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4. Instability

HypothesisD: Especiallywithinformationimperfections,marketadjustmentstoaperturbationfromequilibriummaybe(locally) destablizing

Questionnotaskedbystandardtheorem Partialequilibriummodelssuggeststability ButFisher/Greenwald/Stiglitz

pricedebtdynamicssuggest

otherwise Withunemployment,wageandpricedeclinesoreven

increasesthatarelessthanexpectedcanloweremploymentandaggregatedemand,andcanhaveassetpriceeffectswhichfurther

Loweraggregatedemandandincreaseunemploymentand Loweraggregatesupplyandincreaseunemploymentstill

further


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Thiscrisis

Combineselementsofincreasedrisk,reducedqualityofinformation,astructuraltransformation,withtwomoreingredients:

Growinginequalitydomestically,whichwould

normallyleadtolowersavingsrateExceptinarepresentativeagentmodel

Obfuscatedbygrowingindebtedness,bubble

GrowingglobalreservesRapidlygrowingglobalprecautionarysavings

Effectsobfuscatedbyrealestatebubble


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TowardsaNewMacroeconomics

Shouldbeclearthatstandardmodelswereill equippedtoaddresskeyissuesdiscussedaboveAssumptionsruledoutorignoredmanykeyissues

Manyofrisksrepresentredistributions

Howtheseredistributionsaffectaggregatebehavioriscentral

NewMacroeconomicsneedstoincorporateananalysisofRisk,Information,Institutions,Stability,setinacontextof

Inequality

Globalization

StructuralTransformation


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Withgreatersensitivitytoassumptions(includingmathematicalassumptions)thateffectivelyassumewhatwastobeproved(e.g.withrespecttobenefitsofriskdiversification,effectsof

redistributions)


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AnExample: MonetaryEconomics

withBanks Repositoryofinstitutionalknowledge

(information)thatisnoteasilytransferredInternalizationofinformationexternalities

providesbetterincentivesintheacquisitionof

information

Cost: lackofdirect diversificationofriskThough

shareholder

risk

diversification

can

still

occur

Butriskdiversificationattenuatesinformation

incentives


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BanksstilllocusofmostSMElending

VariabilityinSMEcentraltounderstandingmacroeconomicvariability(employment,

investment)


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Standardmodelsdidntmodelbankingsectorcarefully(oratall)OftensummarizedinamoneydemandequationMayworkOKinnormaltimes

Butnotnow,orinothertimesofcrisis(EastAsia)

Keychannelthroughmonetarypolicyaffectstheeconomyisavailabilityofcredit(GreenwaldStiglitz,2003,TowardsaNewParadigminMonetaryEconomics)Andthetermsatwhichitisavailable(spreadbetweenT

billrateandlendingrate)isanendogenous variable,

whichcanbeaffectedbyconventionalpoliciesandregulatorypolicies)


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Anexample

Assumenochangeincontrol,bankmanagers

maximizeexpected

utility

of

profits

to

old

owners

(dontcareaboutreturnstogovernment)

MaxU()

where =max{(1 )(Y rB rg Bg

),0}

where

representsthedilutiontogovernment

(throughsharesand/orwarrants)andrg

isthe

coupononthepreferredsharesandBg

isthe

capitalinjectionthoughpreferredshares)


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Threestatesofnature(assumingcanorderby

levelofmacroeconomicactivity)(a) 1

: bankgoesbankrupt

(b)

1

2: oldownersmakenoprofit,but

bankdoesnotgobankrupt

(c)

2: bankmakesprofitforoldowners,

preferredsharesarefullypaidFinancingthroughpreferredshares

with/withoutwarrantsvs.equityaffectssize

ofeachregionandweightputoneach


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Ifgovernmentchargesactuariallyfairinterestrate

onpreferredshares,thenrg

>r,so(i)regioninwhich

oldownersmakenoprofitisactuallyincreased;(ii)

largerfractionofgovernmentcompensationinform

ofwarrants,largerregion(a)andlessweightplacedon(a)versus(b)[lessdistorteddecisionmaking]

Optimal: fullshareownership

Worst(withrespecttodecisionmaking): injecting

capitaljustthroughpreferredshares


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ConcludingRemarks

Modelsandpolicyframeworks(includingmanyusedbyCentralBanks)contributedtotheirfailuresbeforeandafter

thecrisis

Andalsoprovidelessguidanceonhowtoachievegrowthwithstability(accesstofinance)

Fortunately,newmodelsprovidealternativeframeworks

Manyofcentralingredientsalreadyavailable Creditavailability/bankingbehavior

Creditinterlinkages

Morebroadly,sensitiveto(i)agencyproblems;(ii)externalities;and

(iii)

broader

set

of

market

failures Modelsbasedonrationalbehaviorandrationalexpectations(even

withinformationasymmetries)cannotfullyexplainwhatisobserved

Buttherecanbesystematicpatternsinirrationality,thatcanbestudiedandincorporatedintoourmodels


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ConcludingRemarks

Lesslikelythatasinglemodel,asimple(butwrong)paradigmwilldominateasitdidinthepast

TradeoffsinmodelingGreaterrealisminmodelingbanking/shadowbanking,key

distributionalissues(lifecycle),keyfinancialmarket

constraints maynecessitatesimplifyinginother,lessimportantdirections

Complexitiesarisingfromintertemporal

maximization

overaninfinitehorizonoffarlessimportancethan

thoseassociatedwithanaccuratedepictionoffinancialmarkets


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NewPolicyFrameworks

Newpolicyframeworksneedtobedevelopedbasedonthisnewmacroeconomicmodeling

Focusnotjustonpricestabilitybutalsoinfinancialstability

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Rethinking Macroeconomics