Homoeconomicus : The Impact - PowerPoint Presentation

Slide1

Homoeconomicus: The Impact of the Economic Crisis on Economic Theory

Joseph E. Stiglitz

Atlanta

January 2010Slide2

Long-Standing Premises of Standard Economics

Economic participants are rational

Firms are profit/value maximizing

Markets are competitive

And under these assumptions market equilibrium is

basically

efficient (Pareto efficient) and “self-correcting”

Some market failures, like pollution,

can

be handled through market mechanisms

Inequalities are socially efficient

Provide incentives

Reflect differences in productivities

Redistributions (“social justice”) can also be handled through market mechanismsSlide3

Crisis Has Exposed Fundamental Flaws

Hard to reconcile

observed

behavior with hypotheses

Marked irrationalities on part of homeowners, investors—and probably financial institution executives

They

may

have been exploiting failures in corporate governance and investor ignorance

But more plausibly, they bought into their own false arguments

Markets were not efficient, not self-correcting (in relevant time framework)

Huge costs borne by every part of society, in trillions of dollarsSlide4

Crisis Has Exposed Fundamental Flaws

Hard to reconcile much of behavior with a fully competitive market

With private returns (bonuses) so huge while social losses for which they were responsible so large, hard to buy into any theory arguing that private rewards correspond to social returns

Undermining basic theory of income distributionSlide5

Many of These Problems Have Been Long Noted

Just dropping the assumption of perfect information destroys all of classical theorems

Markets are not (constrained) Pareto efficient (Greenwald-Stiglitz, 1986)

Invisible hand invisible, partly because

it’s

not there

Pursuit of self-interest (greed) does not necessarily lead to societal well being

Even a small amount of information imperfection can give rise to large amounts of monopoly power (Diamond,

1971;

Stiglitz, 1985)Slide6

Even a small amount of information imperfection can result in competitive equilibrium not existing (Rothschild-Stiglitz, 1976)Even a small amount of information imperfection can destroy law of the single priceFinancial markets cannot be fully efficient—if they were, individuals would not invest in information (Grossman-Stiglitz, 1976, 1980)

Analogous to Schumpeter’s argument for imperfect competition and

innovationSlide7

Underlying NotionsInformation is different from other commoditiesMarkets are rife with agency problems and externalities

In both cases, there may be marked discrepancies between social returns and private rewards

With imperfect information pecuniary externalities matter

Information imperfections are central in financial markets

Failure of financial markets has imposed large externalities on the rest of societySlide8

Previous Crises Have Exposed Problems

There have been repeated financial market failures, repeated bailouts

Evidence of failure of financial institutions to perform critical social roles—allocating capital and managing risk, at low

transaction costs

High

transaction

costs—40% of corporate profits

Confusing ends with means

Credit

boom/bust

cycle largely based on irrationalities

But can

have

bubbles even under rational expectationsSlide9

Market advocates had ignored these lessons both of theory and historyThey were not just theoretical nicetiesQuantitative importance should have been evidentPursued deregulation agenda

With hidden distributive consequences

Giving priority to derivatives claimants in bankruptcy was a major redistribution of wealth against other claimants—hardly discussedSlide10

Examples of IrrationalityMortgage market was predicated on belief that housing prices would go up forever and that interest rates would not increase

Neither assumption was plausible

Especially as real incomes of most Americans

were

declining

And interest rates were at a historical low

Should have been obvious that if housing prices even stagnated or interest rates increased, there would be massive foreclosures

Should have been obvious that if interest rates increased, housing prices were likely even to fallSlide11

Irrationality in Mortgage MarketsGreenspan advised people to take out variable rate mortgages, saying that had they done so (ten years earlier) they would have saved large amounts of moneyBut that was because he had brought interest rates down to unprecedented low levels

When interest rates are at 1%, there was only one way for them to go—up

In efficient markets, on average, costs should be the same

Only issue is risk management

He, and others, didn’t even ask the right questionSlide12

Irrationality in Mortgage Markets100% non-recourse mortgages are an optionIf prices go up, borrower gets gain; if prices go down, lender takes loss

Gift to borrower

Financial markets are not in the business of giving gifts—at least to poor people

What was going on?

Did they not understand the nature of the financial

product?

Or were they exploiting market inefficiencies and individual irrationalities (difficulties individuals have in walking away from homes

)?Slide13

Irrationality in SecuritizationPredicated on zero probability of housing price declines, uncorrelated risksBut as bubble grew, it should have been evident that there was a significant probability of price declinesAnd if interest rates increased, price declines would affect many (most) markets

Models underestimated low probability events

Once in a thousand year events happened every ten yearsSlide14

Irrationality in SecuritizationBelieved that the new products that they were creating had transformed worldBut continued to use data from

recent

past, as if probabilities had not changed

They had transformed the world—probabilities had changed for the worseSlide15

Irrationality in SecuritizationSecuritization had opened up new problems of information asymmetries

Leading to lower quality mortgages

Complex products were so complex that no one could investigate quality of underlying assets—inducing large incentives for asset quality deterioration

Should have anticipated asset price deterioration

Market was based on “fool is born every moment” and the realization that globalization had opened up a global market place for fools

Problems were predictable and predicted

But ignored by those in the financial marketSlide16

Irrationality in SecuritizationComplexity of securitization unnecessarily increased complexity of unwinding problems

Conflicts of

interest

between holders of first and second mortgages and service providers

Especially when holder of second mortgage is the service provider

Has contributed to the difficulties of dealing with foreclosures (renegotiation)

Should have been anticipated—was not Slide17

Irrationality in DerivativesSupposed to help manage riskBut because of high complexity, actually created riskComplex web of interdependencies

Didn’t net out positions

Increasing risk of problems in counterparty default

Said “they couldn’t believe that counterparties would default”

But CDS markets were

betting

on the demise of the counterparties!Slide18

Irrationality (or Deception) in Incentive StructuresSaid to provide high-powered incentives

Fundamental premise questionable: what kind of person would, as CEO, give only 75% of effort because his pay was only $5

million

and didn’t increase with performance

Performance

pay has

always been questionable when performance is hard to measure

Other factors contributing to performance

“Quality” problems;

short-run/long-run

trade-offs

These problems especially important

for

executive compensation

Can increase

short-run

profits at expense of

long-run

performance

Stock performance related to other factorsSlide19

If firms had been serious about performance pay, it should have been based on relative performance (compared to others in industry) (Nalebuff Stiglitz, 1983) The fact that so few firms did so suggests that that was not what this was about

It was about extracting as much rents from firms as possible

Reflecting problems in corporate governanceSlide20

Supported by evidence, which shows little relationship between pay and performanceWhen performance is weak, change compensation schemeEvident in this crisisLarge bonuses even for dismal performanceChanged name to retention pay—but

if

retention pay goes up when performance goes down, then there are

no

incentives associated with (so-called) incentive paySlide21

Incentive pay system was worse than just describedGot rewarded on basis of short-term performance, got high upside return, without bearing downside risk

Induced

short-sighted

behavior, excessive risk taking

Got rewarded for increasing returns by increasing beta (anyone can do that), rather than alpha (“beating the market”)

Reward structures provided incentives for bad information—getting stock prices up

Incentives matter

—encouraged

off-balance

sheet “creative accounting”Slide22

Without good information, markets cannot allocate resources well or manage risk wellIncentive structures thus had negative social valueShareholders and bondholders not served well

No justification for such a reward structure

Did bank management not understand these issues?

Not surprising: most not very economically sophisticated

Or were they just pursuing their own

interests?

Pursuit of

selfSlide23

Markets Exploited Consumer Irrationality and Ignorance

Predatory lending practices in financial markets

Resisted legislation intended to

curb these practices

Continue to do so (including resistance to Financial Products Safety Commission)

Credit cards

Usurious interest rates, high fees

Taking advantage of ignorance/foibles (individuals believe that they will pay

on

time, but often don’t)Slide24

Caught in Their Own Deceptions“Hoisted with their own petard”—predatory loans were first to get into troubleBut attempts to move risks off balance sheet meant that they didn’t know their

own

balance

sheet and

couldn’t know that of others,

leading

to freezing of credit markets

Also meant that while securitization was

supposed

to move risks away from the banks, in the end they were left holding large amounts of riskSlide25

Other Theories Undermined as Well

Devastating effect on equilibrium theories based on rationality

But also devastating effect on “evolutionary”/Schumpeterian theories

Held that markets should be evaluated not on basis of

short-run

performance, but drive for innovation

Big lesson: Not all innovations are socially productive, markets often resist “good” innovationsSlide26

Financial InnovationsWere supposed to help manage riskActually created risk

Hard to identify any increase in overall economic performance that resulted from these financial innovations

Easy to identify large losses in

long-term

performance that resulted from these financial innovationsSlide27

Digression: On the Measurement of Economic Performance and

Social

Progress

GDP is not a “good” measure

Inadequacies were evident in this downturn

Before crisis 40% of profits were in finance

Profits were fictitious—wiped out by losses of crisis, represented largely a transfer payment from taxpayers to banks and bankers

Major source of growth was real estate

But real estate prices were also fictitious—based on bubbles

Growth was not sustainable—mounting debts

Implication: any time series or

cross country

studies making inferences about determinants of productivity (growth) using GDP data

have

to be treated with extreme cautionSlide28

Financial Markets Resisted Good Innovations

Should have focused on designing financial products that helped ordinary individuals manage the risk of homeownership—for most families, their most important asset

New mortgage products increased the risk borne by individuals

There were alternatives

They failed to create them

In some cases, they resisted them (Danish mortgage bonds)Slide29

Long history of resisting innovationsInflation indexed bondsGDP indexed bondsAuctioning T-billsAn efficient

electronic payment

system

Not a

surprise

Expected whenever there are large discrepancies between social returns and private rewards

Markets focus on increasing rentsSlide30

Evolutionary Theories UnderminedFirms that did not “follow” the pack—that had not engaged in excessive leverage and other firms of irrational risk taking—would not have survivedInvestors demanded high returns

Investors failed to understand the associated risks

Firms that had produced “good” innovations may not have been able to market themSlide31

A Moment of Reckoning and Opportunity

Prevalent economic models encouraged policies that contributed to the economic crisis

Economists should be included in the list of those to “blame” for the crisis

Crisis has exposed major flaws in these models

Not minor details

Many of these problems have occurred repeatedly

A window of opportunity: to construct new theories based on more plausible accounts of individual and firm behavior