Homoeconomicus: The Impact
of the Economic Crisis on
Economic Theory
Joseph E. Stiglitz
Atlanta
January 2010
Long-Standing Premises of
Standard Economics
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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
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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