Homoeconomicus: The Impact of the Economic Crisis on

Economic Theory

Joseph E. StiglitzAtlanta

January 2010

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 mechanisms

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 dollars

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

distribution

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)

• 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 price

• Financial 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 innovation

Underlying Notions

• Information is different from other commodities• Markets 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 society

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 expectations

• Market advocates had ignored these lessons both of theory and history– They were not just theoretical niceties– Quantitative importance should have been

evident• Pursued deregulation agenda

– With hidden distributive consequences• Giving priority to derivatives claimants in

bankruptcy was a major redistribution of wealth against other claimants—hardly discussed

Examples of Irrationality• Mortgage 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 fall

Irrationality in Mortgage Markets• Greenspan advised people to take out variable rate

mortgages, saying that had they done so (ten years earlier) they would have saved large amounts of money– But 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 question

Irrationality in Mortgage Markets

• 100% non-recourse mortgages are an option– If 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)?

Irrationality in Securitization

• Predicated on zero probability of housing price declines, uncorrelated risks– But as bubble grew, it should have been evident that

there was a significant probability of price declines– And 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 years

Irrationality in Securitization

• Believed that the new products that they were creating had transformed world

• But continued to use data from recent past, as if probabilities had not changed

• They had transformed the world—probabilities had changed for the worse

Irrationality in Securitization• Securitization 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 market

Irrationality in Securitization

• Complexity 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

Irrationality in Derivatives

• Supposed to help manage risk• But because of high complexity, actually created

risk– Complex 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!

Irrationality (or Deception) in Incentive Structures

• Said 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 factors

• 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 governance

• Supported by evidence, which shows little relationship between pay and performance– When performance is weak, change

compensation scheme– Evident in this crisis

• Large bonuses even for dismal performance• Changed name to retention pay—but if retention pay

goes up when performance goes down, then there are no incentives associated with (so-called) incentive pay

• Incentive pay system was worse than just described– Got 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”

• Without good information, markets cannot allocate resources well or manage risk well

• Incentive structures thus had negative social value• Shareholders 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 self

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)

Caught in Their Own Deceptions

• “Hoisted with their own petard”—predatory loans were first to get into trouble

• But 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 risk

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” innovations

Financial Innovations

• Were supposed to help manage risk• Actually 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 innovations

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 caution

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)

• Long history of resisting innovations– Inflation indexed bonds– GDP indexed bonds– Auctioning T-bills– An efficient electronic payment system

• Not a surprise– Expected whenever there are large discrepancies

between social returns and private rewards– Markets focus on increasing rents

Evolutionary Theories Undermined

• Firms that did not “follow” the pack—that had not engaged in excessive leverage and other firms of irrational risk taking—would not have survived– Investors demanded high returns– Investors failed to understand the associated risks

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

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