RETHINKINGMACROECONOMICS:

WHATWENTWRONGANDHOWTOFIXIT
JosephE.Stiglitz AdamSmithLecture EuropeanEconomicAssociation Glasgow August24,2010

Outline
Thefailuresoftheexistingparadigm
Andthepolicyframeworksbasedonthem

Explainingthefailures:keyassumptions,key omissions
Somemethodologicalremarks

Keyunansweredquestions Fivehypotheses Newframeworks/models

GeneralConsensus:
Standardeconomicmodelsdidnotpredictthe crisis
Andpredictionisthetestofanyscience

Worse:Mostofthestandardmodels(including thoseusedbypolicymakers)arguedthatbubbles couldnt exist,becausemarketsareefficientand stable

Manyofthestandardmodelsassumedtherecouldbe nounemployment(labormarketsclear) Iftherewasunemployment,itwasbecauseofwage rigidities
Implyingcountrieswithmoreflexiblelabormarketswould havelowerunemployment

SixFlawsinPolicyFramework
Policymakingframeworksbasedonthatmodel(or conventionalwisdom)wereequallyflawed Maintainingpricestabilityisnecessaryand almostsufficientforgrowthandstability
ItisnottheroleoftheFedtoensurestabilityofasset prices

Markets,bythemselves,areefficient,self correcting
Canthereforerelyonselfregulation

Inparticular,therecannotbebubbles
Justalittlefrothinthehousingmarket

ConventionalPolicyWisdom
Eveniftheremightbeabubble,couldntbesure,until afteritbreaks Andinanycase,theinterestrateisabluntinstrument
Usingittobreakbubblewilldistorteconomyandhave otheradversesideeffects

Lessexpensivetocleanupaproblemafterbubble breaks IMPLICATION:DONOTHING Expectedbenefitsmall,expectedcostlarge EACHOFTHESEPROPOSITIONSISFLAWED

1.Inflationtargeting
Distortionsfromrelativecommoditypricesbeingoutof equilibriumasaresultofinflationaresecondorder relativetolossesfromfinancialsectordistortions
Bothbeforethecrisis,evenmore,afterthebubblebroke Ensuringlowinflationdoesnotsufficetoensurehighand stablegrowth Moregenerally,nogeneraltheoremthatoptimal responsetoaperturbationleadingtomoreinflationisto raiseinterestrate
Dependsonsourceofdisturbance

Inflationtargetingrisksshiftingattentionaway fromfirstorderconcerns

2.Marketsareneitherefficientnor selfcorrecting
Generaltheorem:wheneverinformationisimperfector riskmarketsincomplete(thatis,always)marketsarenot constrainedParetoefficient(GreenwaldStiglitz)

Pervasiveexternalities Pervasiveagency problems

Manifestinfinancialsector(e.g.intheirincentivestructure)

Greenspanshouldnothavebeensurprisedatriskstheyhad incentivetoundertakeexcessiverisk
Bothattheindividuallevel(agencyproblems) Andorganizational(toobigtofail) Problemsoftoobigtofailbankshadgrownmarkedlyworsein previousdecadeasaresultofrepealofGlassSteagall

Systemicconsequences(whichmarketparticipantswillnot takeintoaccount)arethereasonwehaveregulation
Especiallysignificantwhengovernmentprovides(implicitor explicit)insurance

3.Therecannotbebubbles..
Bubbleshavemarkedcapitalismsincethe beginning Bubblesareevenconsistentwithmodelsof rationalexpectations(Allen,Morris,and Postlewaite 1993)andrationalarbitrage (Abreu andBrunnermeier 2003). Collateralbasedcreditsystemsareespecially pronetobubbles

4.Cantbesure
Allpolicyismadeinthecontextofuncertainty Ashousingpricescontinuedtoincrease eventhoughrealincomesofmostAmericans weredecliningitwasincreasinglylikelythat therewasabubble

5.Wehadnoinstruments
Wehadinstruments Congresshadgiventhemadditionalauthorityin1994 Ifneededmoreauthority,could/shouldhavegonetoCongress toaskforit Couldhaveusedregulations(loantovalueratios)todampen bubble
Hadbeenbrieflymentionedduringtechbubble

Ideologicalcommitmentnottointerveneinthemarket Butsettinginterestratesisaninterventioninthemarket
Generalconsensusontheneedforsuchintervention Ramseytheorem:singleinterventioningeneralnotoptimal Tinbergen:withmultipleobjectivesneedmultipleinstruments Evenwithsingleobjective,withriskpreferabletousemultiple instruments Theyhadmultipleinstruments

6.Lessexpensivetocleanupthe mess
Fewwouldagreewiththattoday Lossbeforethebubblebrokeinhundredsof billions Lossafterthebubbleintrillions

Whatwentwrong?Whydidthe modelsfail?
Allmodelsrepresentsimplification Keyissue:whatwerethecriticalomissionsofthe standardmodels?Whatwerethemostmisleading assumptionsofthemodels?
Answerdependspartlyonthequestionsbeingasked

Widevarietyofmodelsemployed,soanybrief discussionhastoentailsomecaricature Dynamic,stochastic,generalequilibriummodels focusedonthreekeyelements

Macrodynamicscrucial Uncertaintyiscentral Andpartialequilibriummodelsarelikelytobemisleading

KeyProblem
Notwithdynamicstochasticgeneralequilibrium analysisbutspecificassumptions
Needtosimplifysomewhere ProblemisthatStandardModelsmadewrong simplifications
Inrepresentativeagentmodels,thereisnoscopeforinformation asymmetries(exceptwithacuteschizophrenia) Inrepresentativeagentmodels,thereisnoscopefor redistributiveeffects Inrepresentativeagentmodels,thereisnoscopeforafinancial sector
Whoislendingtowhom?Andwhatdoesbankruptcymean?

Argumentsforsimplifications uncompelling
Needtoreconcilemacro withmicroeconomics, deriveaggregaterelationsfrommicrofoundations
Butstandardmicrotheoryputsfewrestrictionson aggregatedemandfunctions(Mantel,Sonnenschein)
Restrictionsresultfromassumingrepresentativeagent

Hardtoreconcilemacrobehaviorwithreasonable specifications(e.g.laborsupply,riskaversion) Importanttoderivemacrobehaviorfromright micro foundations

Consistentwithactualbehavior Takingintoaccountinformationasymmetries,imperfections

Goingforward:exploreimplicationsofdifferentsimplifications

RecentProgress
RecentDSGEmodelshavegonebeyond representativeagentmodelsand incorporatedcapitalmarketimperfections
Questionremains:Havetheyincorporatedkey sourcesofheterogeneityandcapitalmarket imperfections
Lifecyclecentraltobehaviormodelswithinfinitely livedindividualshavenolifecycle Factordistributionkeytoincome/wealthdistribution

 Equityandcreditconstraintsbothplayakeyrole Asdodifferencesbetweenbankandshadowbanking system Somenotablesuccesses(Korinek,JeaneKorinek)

AskingtheRightQuestions
Testofagoodmacromodelisnotwhetherit predictsalittlebetterinnormal times,but whetheritanticipatesabnormaltimesand describeswhathappensthen
Blackholesnormally dontoccur Standardeconomicmethodologywouldtherefore discardphysicsmodelsinwhichtheyplayacentral role Recessionisapathologythroughwhichwecancome tounderstandbetterthefunctioningofanormal economy

Majorpuzzle:Fastdeclines,slow recoveries
1. Intheabsenceofwar,statevariables(capitalstocks)change slowly.Whythencanthestateoftheeconomychangeso quickly?
Importanceofexpectations
Butthatjustpushesthequestionbackfurther:whyshouldexpectations changesodramatically,withoutanybignews?
EspeciallywithrationalindividualsformingBayesianexpectations PuzzleofOctober,1987HowcouldaquarterofthePDVofthecapitalstock disappearovernight?

Discretegovernmentpolicychanges
Removingimplicitgovernmentguarantee(adiscreteaction) Dramaticincreasesininterestrates(EastAsia) Butthesediscretepolicychangesusuallyarearesultofsudden changes instateofeconomy
Thoughintendedtodampentheeffects,theysometimeshaveoppositeeffectof amplification

LargeChangesinStateofEconomy fromSmallChangesinState Variables

Consequenceofimportantnonlinearities in economicstructure
Familiarfromoldnonlinearbusinesscyclemodels (Goodwin)

Individualsfacingcreditconstraints
Leadingtoendofbubble Thoughwithindividualheterogeneity,eventhen therecan/shouldbesomesmoothing

FastDeclines
Whatevercause,changesinexpectationscangiverise tolargechangesin(asset)prices Andwhatevercause,effectsoflargechangesinprices canbeamplified byeconomicstructure(withfollow oneffectsthatareprolonged) Understandingamplificationshouldbeoneofkey objectivesofresearch

Amplification
Financialaccelerator(derivedfromcapitalmarket imperfectionsrelatedtoinformationasymmetries) (GreenwaldStiglitz,1993,BernankeGertler,1995) Trendreinforcement effectsinstochasticmodels (Battiston etal2010) Newuncertainties: Largechangesinpricesleadtolargeincreasesin uncertaintiesaboutnetworthofdifferentmarket participants abilitytofulfillcontracts Changesinriskperceptions(notjustmeans)matter Crisisshowedthatprevailingbeliefsmightnotbecorrect Anddramaticallyincreaseduncertainties

AmplificationsImplyFastDeclines
NewInformationimperfections
Anylargechangeinpricescangiverisetoinformation asymmetries/imperfectionswithrealconsequences Indeed,evenasmallchangeinpricescanhavefirstordereffectson welfare(andbehavior)
Unlikestandardmodel,wheremarketequilibriumisPO(envelopetheorem

Redistributions
Withlargepricechanges,largegamblestherecanbefast redistributions(balancesheeteffects)withlargereal consequences Especiallyiftherearelargedifferencesamongindividuals/firms Withsomefacingconstraints,othersnot

 Control
Whoexercisescontrolmatters(unlikestandardneoclassical model) Canbediscretechangesinbehavior Withbankruptcyandredistributions,therecanbequick changesincontrol

2.SlowRecovery
Therewerelargelossesassociatedwithmisallocationof capitalbeforethebubblebroke.Itiseasytoconstruct modelsofbubbles.Butmostofthelossesoccurafterthe bubblebreaks,inthepersistentgapbetweenactualand potentialoutput
Standardtheorypredictsarelativelyquickrecovery,asthe economyadjuststonewreality
Newequilibriumassociatedwithnewstatevariables(treating expectationsasastatevariable)

Andsometimesthatisthecase(Vshapedrecovery) Butsometimestherecoveryisveryslow
Persistenceofeffectsofshocks (partiallyexplainedbyinformation/creditmarketimperfections (GreenwaldStiglitz))rebuildingbalancesheetstakestime

FightoverWhoBearsLosses
Afterbubblebreaks,claimsonassetsexceedvalueofassets Someonehastobearlosses;fightisoverwhobearslosses Fightoverwhobearslossesandresultingambiguityinlong termownershipcontributestoslowrecovery
Standardresultintheoryofbargainingwithasymmetricinformation

Threewaysofresolving
Inflation Bankruptcy/assetrestructuring Muddlingthrough(nontransparentaccountingavoidingbank recapitalization,slowforeclosure) Americahaschosenthirdcourse

NewFrameworks
Frameworksfocusingon 1. Risk 2. Informationimperfections 3. Structuraltransformation 4. Stability

andFourHypotheses
HypothesisA:Therehavebeenlarge(andoftenadverse) changesintheeconomysriskproperties,inspiteof supposedimprovementsinmarkets HypothesisB:Movingfrombanks tomarkets predictablyledtodeteriorationinqualityofinformation HypothesisC:structuraltransformationsmaybe associatedwithextendedperiodsofunderutilizationof resources HypothesisD:Especiallywithinformationimperfections, marketadjustmentstoaperturbationfromequilibrium maybe(locally)destablizing

UnderlyingTheorem
Marketsarenotingeneral(constrained) Paretoefficient
Onceasymmetriesininformation/imperfections ofriskmarketsaretakenintoaccount

Noraretheystable
Inresponsetosmallperturbations Andevenlesssoinresponsetolargedisturbances associatedwithstructuraltransformation

NewFrameworksandHypotheses
1. Risk:Acentralquestioninmacroeconomicanalysis shouldbeananalysisoftheeconomysriskproperties(its exposuretorisk,howitamplifiesordampensshocks, etc).

HypothesisA:Therehavebeenlarge(andoftenadverse) changesintheeconomysriskproperties,inspiteofsupposed improvementsinmarkets

Liberalizationexposescountriestomorerisks Automaticstabilizers,butalsoautomaticdestabilizers
Changesfromdefinedbenefittodefinedcontributionsystems Capitaladequacystandardscanactasautomaticdestabilizers Floatingratemortgages Changeinexchangerateregime

Privatelyprofitableinnovations mayhavesociallyadverse effects

CorollaryofGreenwaldStiglitz Theorem

Insufficientattentiontoarchitecture ofrisk
Theorywasthatdiversificationwouldleadtolowerrisk, morestableeconomy
Didnthappen:wheredidtheorygowrong? Mathematics:
Madeassumptionsinwhichspreadingrisknecessarilyincreases expectedutility Withnonconvexities(e.g.associatedwithbankruptcy,R&D)itcan leadtolowereconomicperformance

Twosidesreflectedinstandarddebate
Beforecrisisadvantagesofglobalization Aftercrisesrisksofcontagion Bankbailoutseparateoutgoodloansfrombad(unmixing)

Standardmodelsonlyreflectformer,notlatter
Shouldreflectboth Optimalelectricgrids Circuitbreakers

NewResearch
Recentresearchreflectingboth
Fullintegrationmayneverbedesirable Stiglitz,AER 2010,JournalofGlobalizationand Development,2010: Inlifecyclemodel,capitalmarketliberalization increasesconsumptionvolatilityandmaylower expectedutility Stiglitz,OxfordReviewofEconomicPolicyOxford ReviewofEconomicPolicy,2004

NewResearch
Showinghoweconomicstructures,including interlinkages,interdependenciescanaffect systemicrisk
Privatelyprofitableinterlinkages (contracts)are not,ingeneral,constrainedParetoefficient
AnothercorollaryofGreenwaldStiglitz 1986

Interconnectivitycanhelpabsorbsmallshocksbut exacerbatelargeshocks,canbebeneficialingood timesbutdetrimentalinbadtimes

Furtherresults:DesignMatters
Poorlydesignedstructurescanincreasesrisk ofbankruptcycascades
Greenwald&Stiglitz (2003),AllenGale(2000)

Hubsystemsmaybemorevulnerabletosystemic riskassociatedwithcertaintypesofshocks
Manyfinancialsystemshaveconcentratednodes

Circuitbreakerscanaffectsystemicstability Realproblemincontagionisnotthose countriessufferingfromcrisis(dealingwith thatisakintosymptomaticrelief)butthe hubsintheadvancedindustrialcountry

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

Canbeaffectedbypolicyframeworks
Bankruptcy law(indenturedservitude)
Lendersmaytakelesscareingivingloans (Miller/Stiglitz,1999,2010)

Morecompetitivebankingsystemlowersfranchisevalue
Mayleadtoexcessiverisktaking
(Hellman,Murdock,andStiglitz,2000)

Excessiverelianceoncapitaladequacystandardscanleadto increasedamplification(unlesscyclicallyadjusted) Capitalmarketliberalization

Flowsintoandoutofcountrycanincreaseriskofinstability

Financialmarketliberalization
Mayhaveplayedaroleinspreadingcrisis InmanyLDCs,liberalizationhasbeenassociatedwithless lendingtoSMEs

2.Informationimperfectionsand asymmetriesarecentral
Explaincreditandequityrationing
Keytounderstandingfinancialaccelerator Keytounderstandingpersistence(GreenwaldStiglitz (1993)

Whybanksplaycentralroleinoureconomy
Andwhyquicklossofbankcapital(andbank bankruptcy)canhavelargeandpersistenteffects

Changesinthequalityofinformation canhave adverseeffectsontheperformanceofthe economy

Includingitsabilitytomanagerisk

HypothesisB:Movingfrombanks tomarkets predictablyledtodeteriorationinqualityofinformation

Inherentinformationprobleminmarkets Thepublicgoodisapublicgood Goodinformation/managementisapublicgood Shadowbankingsystemnotasubstituteforbankingsystem Leadingtodeteriorationinqualityoflending
Inherentproblemsinratingagencies

Butalsoincreasedproblemsassociatedwithrenegotiationof contracts(Increasinglitigationrisk) Improvingmarkets mayleadtolowerinformationcontentin markets

ExtensionofGrossmanStiglitz Problemsposedbyflashtrading?(Inzerosumgame,more informationrentsappropriatedbythoselookingatbehaviorofthose whogatherandprocessinformation)

Again:Marketequilibriumisnotin generalefficient
Derivativesmarketanexample Largefractionofmarketoverthecounter,nontransparent Hugeexposuresinbillions Previousdiscussionemphasizedrisksposedbyinterconnectivity Furtherproblemsposedbylackoftransparencyofoverthecounter market Underminingabilitytohavemarketdiscipline Marketcouldntassessriskstowhichfirmwasexposed Impededbasicnotionsofdecentralizibility
Neededtoknowriskpositionofcounterparties,inaninfiniteweb

Explaininglackoftransparency: Ensuringthatthosewhogatheredinformationgotinformation rents? Exploitationofmarketignorance? Corruption(asinIPOscandalsinUSearlierindecade)?

3.StructuralTransformation
GreatDepressionwasaperiodofstructural transformationmovefromagriculturalto industry;GreatRecessionisanotherperiodof structuraltransformation(frommanufacturingto servicesector,inducedbyproductivityincreases andchangesincomparativeadvantagebrought onbyglobalization)
Rationalexpectationsmodelsprovidelittleinsightsin thesesituations Periodsofhighuncertainty,information imperfections

HypothesisC:structuraltransformationsmaybeassociated withextendedperiodsofunderutilizationofresources Withelasticityofdemandlessthanunity,sectorwithhigh productivityhasdecliningincome Theremaybehighcapitalcosts(includingindividual specificnoncollateralizable investments)associatedwith transitionbutwithdecliningincomes,itmaybe impossibletofinancetransitionprivately

Capitalmarketimperfectionsrelatedtoinformationasymmetries

Decliningincomesintrapped highproductivitysectorhas adverseeffectonothersectors

4.Instability
HypothesisD:Especiallywithinformationimperfections, marketadjustmentstoaperturbationfromequilibrium maybe(locally)destablizing Questionnotaskedbystandardtheorem Partialequilibriummodelssuggeststability ButFisher/Greenwald/Stiglitz pricedebtdynamicssuggest otherwise
Withunemployment,wageandpricedeclinesoreven increasesthatarelessthanexpectedcanloweremployment andaggregatedemand,andcanhaveassetpriceeffectswhich further Loweraggregatedemandandincreaseunemploymentand Loweraggregatesupplyandincreaseunemploymentstill further

Thiscrisis
Combineselementsofincreasedrisk,reduced qualityofinformation,astructural transformation,withtwomoreingredients: Growinginequalitydomestically,whichwould normallyleadtolowersavingsrate
Exceptinarepresentativeagentmodel Obfuscatedbygrowingindebtedness,bubble

Growingglobalreserves
Rapidlygrowingglobalprecautionarysavings Effectsobfuscatedbyrealestatebubble

TowardsaNewMacroeconomics
Shouldbeclearthatstandardmodelswereill equippedtoaddresskeyissuesdiscussedabove
Assumptionsruledoutorignoredmanykeyissues
Manyofrisksrepresentredistributions Howtheseredistributionsaffectaggregatebehavioriscentral

NewMacroeconomicsneedstoincorporatean analysisofRisk,Information,Institutions,Stability, setinacontextof

Inequality Globalization StructuralTransformation

 Withgreatersensitivitytoassumptions(including mathematicalassumptions)thateffectively assumewhatwastobeproved(e.g.withrespect tobenefitsofriskdiversification,effectsof redistributions)

AnExample:MonetaryEconomics withBanks
Repositoryofinstitutionalknowledge (information)thatisnoteasilytransferred
Internalizationofinformationexternalities providesbetterincentivesintheacquisitionof information Cost:lackofdirect diversificationofrisk
Thoughshareholderriskdiversificationcanstilloccur

Butriskdiversificationattenuatesinformation incentives

 BanksstilllocusofmostSMElending
VariabilityinSMEcentraltounderstanding macroeconomicvariability(employment, investment)

 Standardmodelsdidntmodelbankingsectorcarefully (oratall)
Oftensummarizedinamoneydemandequation MayworkOKinnormaltimes Butnotnow,orinothertimesofcrisis(EastAsia)

Keychannelthroughmonetarypolicyaffectsthe economyisavailabilityofcredit(GreenwaldStiglitz, 2003,TowardsaNewParadigminMonetary Economics)

Andthetermsatwhichitisavailable(spreadbetweenT billrateandlendingrate)isanendogenous variable, whichcanbeaffectedbyconventionalpoliciesand regulatorypolicies)

 Lackofmodelofbankingmeantmonetary authoritieshadlittletosayaboutbestwayof restructuringbanks

Infacttotalconfusion Inabilitytorestartlendingnowshouldnotbea surprise But,withinterestratesnearzero,itisnot (standard)liquiditytrap

Implicitassumptionsinmuchofdiscussionon howbankmanagerswouldtreatgovernment

Anexample
Assumenochangeincontrol,bankmanagers maximizeexpectedutilityofprofitstooldowners (dontcareaboutreturnstogovernment) MaxU() where =max{(1 )(Y rB rgBg),0} where representsthedilutiontogovernment (throughsharesand/orwarrants)andrg isthe coupononthepreferredsharesandBg isthe capitalinjectionthoughpreferredshares)

Threestatesofnature(assumingcanorderby levelofmacroeconomicactivity)
(a) 1 :bankgoesbankrupt (b) 1 2:oldownersmakenoprofit,but bankdoesnotgobankrupt (c) 2:bankmakesprofitforoldowners, preferredsharesarefullypaid

Financingthroughpreferredshares with/withoutwarrantsvs.equityaffectssize ofeachregionandweightputoneach

 Ifgovernmentchargesactuariallyfairinterestrate onpreferredshares,thenrg >r,so(i)regioninwhich oldownersmakenoprofitisactuallyincreased;(ii) largerfractionofgovernmentcompensationinform ofwarrants,largerregion(a)andlessweightplaced on(a)versus(b)[lessdistorteddecisionmaking] Optimal:fullshareownership Worst(withrespecttodecisionmaking):injecting capitaljustthroughpreferredshares

ConcludingRemarks
Modelsandpolicyframeworks(includingmanyusedby CentralBanks)contributedtotheirfailuresbeforeandafter thecrisis
Andalsoprovidelessguidanceonhowtoachievegrowthwith stability(accesstofinance)

Fortunately,newmodelsprovidealternativeframeworks
Manyofcentralingredientsalreadyavailable Creditavailability/bankingbehavior Creditinterlinkages Morebroadly,sensitiveto(i)agencyproblems;(ii)externalities;and (iii)broadersetofmarketfailures Modelsbasedonrationalbehaviorandrationalexpectations(even withinformationasymmetries)cannotfullyexplainwhatisobserved Buttherecanbesystematicpatternsinirrationality,thatcanbe studiedandincorporatedintoourmodels

ConcludingRemarks
Lesslikelythatasinglemodel,asimple(butwrong)paradigm willdominateasitdidinthepast Tradeoffsinmodeling Greaterrealisminmodelingbanking/shadowbanking,key distributionalissues(lifecycle),keyfinancialmarket constraintsmaynecessitatesimplifyinginother,less importantdirections Complexitiesarisingfromintertemporal maximization overaninfinitehorizonoffarlessimportancethan thoseassociatedwithanaccuratedepictionoffinancial markets

NewPolicyFrameworks
Newpolicyframeworksneedtobedevelopedbased onthisnewmacroeconomicmodeling
Focusnotjustonpricestabilitybutalsoinfinancial stability