Homoeconomicus: The Impact of the Economic Crisis on Economic Theory Joseph E. Stiglitz Atlanta 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