(Lecture given by Joseph Stiglitz at the Meetings of the Nobel Laureates, 2008, Lindau, Germany)
Well, thank you very much.
What I’m going to do this morning is in a sense to continue the discussion that began yesterday.
But the focus of my concern is not so much about economic policy, but much more about
what we learn for economic theory and what implications it has for research agenda.
The current economic crisis I would argue has many lessons for economists.
In a sense this is probably the most serious economic disturbance in the US since the depression.
Most economic downturns have been inventory cycles or the Fed stepping on the breaks too hard.
In both those cases the downturns had no implications for the structure of the economy but this economic downturn as a result of a major
financial mistakes and in many ways is related to the frequent financial crises that we’ve seen in developing countries.
There’s been some hundred crises in developing countries over the last 30 – 35 years.
It’s also somewhat akin to the S&L crisis that happened in the USA in the late 80s, which lead in turn to the 1991 recession.
And it’s because this is quite different from the typical economic downturn, the inventory cycle or the Fed stepping on the brakes too hard
that this really gives us a chance to gather I think some important and new economic insights.
In medicine one often studies pathology to learn a great deal about the human body.
The most interesting, important part of research strategy is not normality, but it’s the abnormalities from which we learn a great deal.
In normal times, growth today, output today is 1.03% of what it was last year and it is very hard to differentiate among alternative
hypotheses about what determines economic performance.
So, one of the reasons why this is such an interesting event for an economist not for the people who are suffering, but for economist it’s
so interesting because it helps discriminate among alternative hypotheses.
For instance, the last really big pathological episode you might say, the Great Depression, lead to some important and new insights into how
periods of unemployment could persist.
Standard economic wisdom had it that the economy had self-restorative forces, that you could not have persistent unemployment.
It was clear that something was wrong with those theories and it lead to insights like Keynesism economics.
It led to a conclusion that markets are not self-adjusting.
That there was a role for government to maintain an economy at full employment and then it gave rise to a large subsequent literature on
what were the sources of market failure.
What was wrong with the earlier theories, what was clearly wrong, clearly didn’t describe what was going on, and even today there is some
disagreement about the answer to that question.
After the Great Depression there arose, partly under the influence of Paul Sanderson, a notion, an idea called neoclassical synthesis.
This was the belief that once markets were restored to full employment, the neoclassical principles,
the notion that markets are efficient, would apply.
So, in other words there were two regimes.
These two regimes are reflected in the way we typically teach economics.
You have macroeconomics which is concerned with how to maintain the economy at full employment and then the notion is once we have full
employment standard microeconomics with efficient resource allocations applies.
The neoclassical synthesis I want to emphasize was not a theorem.
It was not based on either theory or empirical evidence.
It was a religious belief, it was a convenient religious belief because people didn’t want to discard all the microeconomics that they
worked so hard to learn and no one wants to see their human capital disappear overnight.
So, but the idea of the neoclassical synthesis was always suspect because it argued that imperfections only appear in large forms, massive
in forms of recessions, depressions, but the question is why should market failures only occur in big doses.
Alternatively one could view recessions as the tip of the iceberg.
There are many smaller market failures associated with imperfect information, incomplete markets,
irrational behaviour, but these are harder to detect.
So, if you are religiously devoted to the notion that markets are efficient, there’re not so big that you can ignore them in the way you
simply could ignore the inefficiencies when the economy has 1 out of 4 people unemployed.
It is so hard to say the market is efficient, but the others are harder to be sure that there is an inefficiency.
There are some examples that we have explored, where you can see very clearly that the markets are massively inefficient at the
microeconomic level and those are the huge tax paradoxes that I began, for instance, writing about in 1973.
The dividend paradox, where you can show that there are ways for firms to distribute money from the corporate sector to the household sector
that would literally save billions and billions of dollars.
The problem is that typically we don’t know the information set facing the firms.
We don’t know the technology, but tax technology we do understand.
It’s in a few volumes 10, 15 volumes of the tax code and therefore we can ascertain whether firms are minimizing tax liabilities.
And the answer is very clearly in a wide variety of cases they are not and not doing so on a very large scale.
What is interesting about the current economic downturn is, it is a microeconomic failure
which in turn is leading to a macroeconomic failure.
Financial markets as was pointed out in the discussion yesterday are supposed to allocate capital and manage risk, but they misallocated
capital on a massive scale, they mismanaged risk.
And as I pointed out they did not create risk products that would have enabled individuals to manage the risk that they face and yet they
were generously compensated some 30-40% of corporate profits were garnered by the financial sector.
And what this suggests, doesn’t prove, but suggests that there was a mismatch between private rewards and social returns, the social returns
in fact may in fact in some aspects be in fact be negative.
So, what we want to try to do is to understand, why are there these massive market failures, to try to see what this recent experience has
to say about...for economic theory and for alternative economic theories
which have been particularly fashionable for instance in macroeconomics in recent decades.
I want to begin by articulating, you may call, a general theorem which is that whenever information is imperfect or market is incomplete,
that is to say always, markets are not constrained Pareto efficient.
This is the opposite of fundamental theorem of welfare economics.
The fundamental theorem of welfare economic said that competitive equilibrium leads to efficient resource allocations.
But hidden in that theorem, Airo de Brouth theorem, are some assumptions that are not normally articulated.
Assumptions such as there is perfect information and one that was articulated that there is a complete set of markets.
When we use the term constrained Pareto efficient what I mean is taking into account the cost of information,
the cost of creating new markets, of collecting information.
So, we are not making the artificial comparison between a world in which there is perfect information and a world which is imperfect.
It’s taking the real cost of information and saying that there are always interventions on the part of the government that could make some
individuals better off without making anybody else worse off.
The way we articulated the theorem was to show that in effect pecuniary externalities always matter in these circumstances.
At the bottom of some of these slides I have given some of the references to the theoretical work on which this is based.
Well, there are several direct applications of this.
One of them is the securitization.
Yesterday’s discussion there were a lot of emphasis on the failures of securitization.
While securitization enhances opportunities for diversification it creates a new agency problem, a new asymmetry of information.
The important thing to recognize is that the resulting market equilibrium will not in general be constrained Pareto efficient and this is
the fundamental result that those in the financial markets have never really taken aboard.
In a sense the simple version of this, I’ll come back to a more complicated version later on, is that the originator of the mortgages did
not have sufficient incentives to screen and monitor and the consequences of that moral hazard problem
are some of the things that we are having to cope with today.
But there are other examples.
Even if there had been more collateral demanded there are problems on lending based on collateral and you can see that in some sense in the
dynamic processes that we’ve seen.
That increased prices of houses increases the collateral value.
It leads to increased demanding, increased demand for housing leads to increased prices.
The net result of this is that you can show in a very simple equilibrium model that there is the possibility of socially excessive lending
and dynamics that give rise to bubbles.
Very similar problems arise in, for instance at the national level, in the denomination and amount of borrowing.
Countries have to make a decision, individuals within countries make a decision about how much to borrow and in what currency to borrow.
That in turn has effects on the probability distributions in future periods of exchange rates.
That’s a pecuniary externality.
That probability distribution is a pecuniary externality, in the absence of a complete set of insurance markets
and there are not a complete set of insurance markets.
That pecuniary externality matters and the resulting market equilibrium is not Pareto optimal.
There are ..it is desirable in general to have government interventions in these markets.
Well, this framework, either in the simple static equilibrium kind of context that Greenboat and I explored or the more dynamic context that
for instance in the paper that I did with Marcus Miller, while it provides an intellectual framework around which to think about what went
on, it is not really fully explained what went wrong.
In fact it is hard to reconcile behaviour with rationality or even rational herding behaviour.
Many individuals clearly borrowed beyond their ability to repay and this should have been obvious to both the borrower and the lender.
But there is an asymmetry, those in the financial markets, on the supply side, were supposed to be financially sophisticated.
The borrowers were told don’t worry, if there were very peculiary mortgages in the States with negative level of amortization.
In other words at the end of the year you owed more than at the beginning of the year.
You didn’t even pay interest.
They said don’t worry you’re more in debt but the value of your asset will have gone up so much so that you’ll be richer.
Now, in a sense they were telling these financially unsophisticated borrowers there is a free lunch.
The more you borrow the richer you are going to be.
One should have been suspect but it was basically based on a pyramid scheme.
And it was a pyramid scheme that, at least those who were financially sophisticated should have understood, couldn’t go on because how could
low income individuals continue to pay more and more, when in fact if you looked at real incomes in the USA, the real income at the bottom
half or more has been falling since 1999.
It’s today lower than it was in 1999.
So, in a sense it was impossible.
Housing prices to continue to go up and up when all the trends of real incomes were going down.
So, it should have been realized that something very peculiar was going on.
Hard to reconcile with rationality.
Similarly I mentioned yesterday the fact that zero or negative down payment non-recourse mortgages are an option.
Issuing such option as equivalent to giving away money and giving away money is hard to reconcile with profit maximizing behaviour.
It certainly has not been a typical part of the business model of most banks.
They give away money to their CEO’s but not to poor people that they don’t know.
It is hard to reconcile with profit maximizing behaviour, unless there is an underlying belief in the irrationality of borrowers that they
won’t exercise the options or of those to whom one will sell the mortgages.
There was here an understanding that many people in Europe did not understand that we had non-recourse mortgages.
It was based on the belief that a fool was born every moment and that they could find those fools particularly here in Europe.
Or it could have been part of a scheme of fraud?
In fact the design was an invitation to fraud and the conflicts of interest made these all the more likely.
Some of the appraisal companies were actually owned by the mortgage origination companies.
One of the things though that is hard to reconcile is how so many market participants ignored all what was going on.
So, yesterday there was a discussion for instance that the moral hazard problems
that the originators of the mortgage didn’t have an incentive as they sold on the mortgage.
But it doesn’t explain why the buyers of these products weren’t more cautious.
And I think the only answer is the stuff that a fool is born every minute and that the mortgage originators may not have been good in
screening but they were good in finding these fools.
The standard models and policy prescriptions used by the central bank really did not anticipate the problem.
Indeed in many ways they made it worse.
About a year ago, actually last January, I was in a meeting in Davos when a discussion of the financial crisis which was beginning to unfold
then and in the front row there were a number of central bankers.
And their response to this criticism is who could have predicted these problems.
The only thing....problem was also in the front row were about 3 or 4 people
who in the previous year in Davos including me had actually predicted this.
And not only had predicted it, had actually described most of the relevant dimensions of what was going on.
And economists are good at identifying the underlying forces.
They’re not very good at timing and of course timing is important if you want to make money, so, that’s why economists remain as academics.
But the fact is the underlying forces were very, very clear.
As I said the central bankers, the USA, Greenspan denied the existence of a bubble, said there was a little froth, encouraged people to take
out a variable rate mortgages when interest rates were at record lows,
with individuals borrowing to capacity and likelihood that interest rates would go up.
It was clearly a recipe for disaster, but one of the interesting things is that they denied any ability to ascertain that there was a bubble
and this is an important issue from a research point of view.
Yes, you cannot be sure that there’s a bubble until after it breaks, but the relevant question from a policy maker is not certainty.
You never make decisions under certainty.
The whole life is making decision under uncertainty.
And the question is, can one say that under certain situations that there is an increase in probability of a problem?
And good policy making, the response to trying to gather data that allows one to make probabilistic statements,
with those probabilistic statements changing as circumstances change.
So, for instance, in the aftermath of the ‘97/’98 crisis I did a paper with Jason Furman where we asked the question could one have
anticipated, were some countries more vulnerable, more higher probability.
It’s an appropriate model of having a crisis than others what were the factors that determined this and the reason I emphasize this is that
it is really an important research area where too little work has been done.
But clearly this work, work of Shiller and basic economics of asking how could prices keep going up when the real incomes of most Americans
was declining, would have led one to the conclusion that the economy was seriously at risk.
The central bankers, in the context of for instance Basle II believed in self-regulation, which I view as an oxymoron.
It believed that if there were a problem that it would be easy to fix and actually Greenspan said that.
But he didn’t go onto say ‘Yes, it may be easy to fix, but it will cost our taxpayers billions and billions of dollars’.
It argued that the interest rate was too blunt of an instrument focusing just on inflation.
If it tried to control the asset price bubble, it would interfere with the focus on current markets.
But the central bank refused to use all the instruments at its disposal.
It rejected in effect a number of regulatory instruments, including regulations that would have reduced the scope for predatory lending, and
even though one of the federal governors actually tried to get them to act particularly in the issue of predatory lending.
In fact, in some remarks I’m going to come to in minute, modern theories of credit markets focus on the fact that actually you can’t really
separate regulatory behaviour from standard macroeconomic, open-market operations.
One of the main theses of the book that I wrote with Bruce Greenwald Toward a New Paradigm in Monetary Economics.
So, the problem was in some sense that central banks focused on the models
on which probably many of you focused on your courses, unfortunately.
Which is centred on second order problems.
The micro-misallocations that occur for instance when relative prices get misaligned as a result of inflation.
These are some of the standard models that had become fashionable in central banks.
But the first order problem, the integrity of the financial system, was totally ignored.
And it seems to me that this is really a central concern.
The kinds of models that are used, that are taught to you, and that are used by many central banks really don’t focus in the way that they
should on the kinds of aspects of the central banks, of the financial markets,
they are absolutely essential to the functioning of our economy.
Well, another way of saying this is that the standard model that is used very extensively the representative agent models with rational
expectations and without institutions says none of this is a problem.
Misallocations in fact could not have happened.
Market participants were acting on the best information available.
It was simply a negative shock with some redistributions.
But when you use a representative agent model redistributions don’t matter.
Economy simply goes on from where we are now with a new capital stock as if nothing had happened.
You just recalibrate down and you go on in the way you would have before.
But I would argue that and I think the evidence is overwhelming and that’s why I say these experiments, as costly as they are to the
economy, do teach us a great deal.
Redistributions and institutions do matter.
The losses in bank capital, bank equity will not be readily replaced.
Those who are offering to recapitalize, for instance, some of the sovereign net wealth firms, are demanding heavy dilution of existing
ownership share claims and this is consistent with the theories of asymmetric information.
With the theories of Levin’s for instance that George explored with the empirical evidence that, for instance, was developed by Askwith and
Moins and with more specific modelling that I did with Bruce Greenwald and Andy Wise.
With loss of bank capital there will be reduced lending.
And what matters is not just interest rates but credit availability.
And as I mentioned before credit availability is affected also by regulations, capital adequacy requirements and risk perceptions.
Now one of the problems that happens after episodes like this, and happened back in the S&L crisis, is that regulators have a tendency to
close the barn door after the horse is out.
So, while they should have had tough regulations prior to the crisis what they do is put the tough regulations after the crisis.
And so with those tougher regulations diminished capital net worth, the result of this is that there is reduced lending.
Moreover in standard monetary economics the focus is always on the T-Bill rate.
But what matters for economic activity for firms is the rate at which they borrow.
And the spread between the borrowing rate and the lending rate is in itself an endogenous variable which has to be studied and analysed and
depends on the variables that I have just described.
So, the consequences with reduced lending, with increased spreads there is going to be a reduced level of economic activities.
The current problems have been exacerbated by a reduction in interbank lending.
And again we can understand what is going on it is a real example of credit constraints,
tightening credit constraints leading to higher lending interest rates.
Banks know that they don’t know their own balance sheet and so can’t know the balance sheet of others.
There are persistent high levels of information asymmetries leading to the kind of market breakdown to which I referred earlier.
An important aspect of this crisis that we should have thought about before are the importances of credit interlinkages.
In fact as important as the interlinkages emphasized in the standard equilibrium model.
You know everybody there’s an old adage about neither a borrower nor a lender be,
but in fact in our economy every firm is both a borrower and a lender and that means there’s a problem in any firm in the economy.
It has implications not only for only the product market but for those it borrows from and to whom it lends.
These credit interlinkages are mediated partly by price mechanism, but partly because of the strong information...
density of information which determines these.
The consequence of this is that bankruptcy in one firm can lead to bankruptcy in other firms, what are called bankruptcy cascades and that
in turn can lead to, I won’t say a collapse in the economic system, but certainly weaknesses.
And this worry about this has very much underlaid the bailouts, but not only the 1998 bailout of LTCM, but the 2008 bailout of Bear Stearns.
These kinds of credit interlinkages simply cannot be studied in the representative agent model.
If there is one person, who is he lending it to, he is lending it to himself.
It is not a very interesting model.
There is an important line of research that has been developing particularly here in Europe
how agent based models and these agent based models are likely to bring more insight.
At the bottom of the page I give one recent research paper that I have written on this, where we explored credit change and bankruptcy
propagation in production networks.
From a policy point of view, it is clear that it will take time to restore bank capital and therefore full restoration of the economy.
And the pace will be affected by the magnitude of the fiscal stimulation.
Again one of the interesting aspects is that no one today really believes in requirity and equivalents.
It would not work if accounting equivalents held or free distributions did matter.
The pace will be affected by the government sponsored capital injections and one of the, I would say sad things about what’s going on, is
that right now the USA is setting a model for other countries of how not to deal with these crises.
As we are engaged in the most non-transparent bailouts that one can imagine with huge wealth transfers.
If what was going on was simply taking some assets off the bank’s balance sheets and selling them for fair market value, there’s no effect
on recapitalisation.
It’s simply a change in the form of the asset, reducing the uncertainty, but not changing the capital value.
But part of what almost surely is going on, reflected in some sense by some of the price effects that you see,
is that there is a recapitalisation.
We don’t really know because it’s all done in such a non-transparent way.
For instance, in the bailout of Bear Stearns there were huge credit and interest rate options embedded in the bailout.
And the granting of the access to the Fed window obviously is an option that was granted to the investment banks, again an option of
enormous value.
The fact that it was denied to Bear Stearns and then granted to other banks really suggests issues of discrimination that raise questions
about the rule of law.
As I pointed out yesterday what was going on at the macro level was an insufficiency of aggregate demand.
I don’t want to say much about that, but it related to both the high oil prices and the demand for T-bills.
As a result of the ‘97/’98 crisis countries wanted, developing countries, building up of literally trillions of dollars of reserves.
At the micro level what was going on was regulatory arbitrage, accounting arbitrage, and distorted incentive systems.
But what we can understand, what I’ve just described, these are the kinds of things
which are standard models that can help us to gain insight.
It’s hard to explain how markets used models that were so bad.
How they underestimated systemic risk, how they underestimated obvious correlations, underestimated the fat-tailed distributions,
overestimated the value of insurance particularly when they didn’t look at the capitalisation of the companies
that were providing the insurance themselves.
They underestimated the potential consequences of the conflicts of interest and the moral hazard problem,
the perverse incentives and the scope of fraud.
So, all these things really make one think much more deeply, in a much more concerned way, about market rationality.
I think in the light of it it’s really hard for anybody to maintain seriously a view that markets were rational.
In fact, if you look more deeply it’s even hard to see the intellectual coherence, for instance those in the market argue that they had
created new products that transformed financial markets and that these justified their high compensation.
Yet, they based their risk assessments on data from before the creation of the new products.
They argued that financial markets were efficient based on spanning theorems, but they based their pricing of the new products on spanning
theorems, yet also argued that they were also creating products that also transformed financial markets.
In fact they were claiming in effect there were billion of dollars on the table that they were picking up.
So, it’s hard to see what was the intellectual coherence and I think you felt some of that in some of the discussion yesterday.
It was individually rational for those in the finance to take advantage of the flawed incentive structures,
but it was not good for the system.
Even if those original mortgages had flawed incentives why didn’t the investors buying the mortgages exercise better oversight.
And the point that I tried to emphasize yesterday is this is not the first time that these problems have occurred.
It occurred repeatedly, repeatedly.
We have these once-in-century, surprises happening every 10 years and it’s also hard to explain.
These are the negative sides.
But also on the other side it’s hard to explain why markets have not made available mortgages
that would have helped individuals manage the risks which they face.
In fact I described yesterday how financial markets consistently have resisted some of the innovations that would have helped individuals
manage the risks that they faced better.
There are alternatives that do a better job, for instance, Danish mortgages and invariable fixed payment, invariable maturity mortgages.
There was a regulatory failure again using wrong models, focusing on wrong thing, it’s ideological.
Those who were appointed irregularly did not believe in regulation and that was why they were appointed.
It is a different kind of notion then, the conventional kind of capture,
because in some sense it wasn’t as if they were bribed or in any other way.
But you appointed people who were in some sense mentally high wired to a particular perspective.
But one shouldn’t ignore the political context.
For instance, if you interview some of the people at the time the appointment was made, in the eighties, they were aware of some of the
consequences for campaign contributions that might be of a consequence of the change in the regulatory structure that would have followed
from having a central banker committed to deregulation.
And if you looked at the negotiations over the design of the Basle II regulation you see
the political role that it’s not just been a technocratic process.
So, that leaves those of you who are engaged in research about regulation to realise that the simple models that economists have tended to
use on regulatory capture are really much too simple.
Another aspect that I could emphasize is that there was a party going on and no-one wanted to be a party pooper.
But the Fed not only failed to dampen the party, but kept it going.
And it had alternatives.
Going forward, what is so clear about what has happened is that the actions by market participants generated externalities with costs borne
by taxpayers, by those who are losing jobs, by those who are losing their homes, by a whole set of other ramifications.
Whenever there is an externality there are grounds for government intervention.
But those in the financial sector would like us just to build better hospitals who do nothing about the underlying prevention and the
underlying contagion of the disease from one part of the economy to another.
And to me this is a totally intellectually incoherent perspective.
If you think that there are going to be hospitals, if you think that the government has to play a role in the bailouts and no one in the
left or the right, or almost no one has said you shouldn’t have done the bailout,
then you have to think what is the appropriate regulatory design.
The question is then can we design interventions that encourage good innovation
and can we avoid the political and economic problems that have marked past regulations?
Regulatory systems have to recognise the asymmetries of information and the asymmetries of salaries that was referred to in some of the
discussion yesterday. Well, this opens up an agenda of policy but also of research.
I’ll come back to that in a second.
Very briefly I talked yesterday about three kinds of regulatory reforms beyond disclosure.
Disclosure is important, but that’s not enough in the recent episode.
The securities were so complex that disclosing them would not have solved the problem.
We need regulations that affect incentives, for instance, the incentives for excessive risk taking, behaviours, putting in speed bumps,
retaining an example that might alleviate some of the problem.
A little bit of what the SPA does today.
Those originating mortgages retain some responsibility for the financial products they created and accounting reforms, also reforms in
structures, financial product safety commission and here we have to think more deeply about how to make regulation work.
For instance, they have representation not just for those who are part of the party, but also for some of those who suffered from the excess
of alcohol, from the drunk-driving that follows on from the party.
Representation of those who are likely to be hurt by unsafe products.
And it’s important to realise that yes there are asymmetries of salaries, but the skills required to certify safety and effectiveness in
drugs or in financial products are different from those entailed in financial market dealing.
We also need a financial market stability commission.
We need separate regulators to look at each of the markets, banks or securities, because of the complexity of each market.
We need people that know about these.
But you need oversight to understand the interactions between the pieces to look at the systemic leveraging and regulatory arbitrage.
The basic point is that financial market regulation is too important to leave to those in the financial sector alone and some aspects need
to be approached on a global scale.
What we have just seen is that the IMF and Basle failed to provide the adequate regulatory framework.
And as I mentioned before the notion underlying Basle II
that banks could be relied upon to assess their own risks seems, at this juncture, absurd.
So, in the last few minutes I want to try to just outline a few elements of the rich research agenda ahead.
So, in a sense this is actually a good time to be a young researcher.
The first is exploring some of the financial market interlinkages that I talked about earlier; the bankruptcy cascades is one example.
Another one that rose several times in discussion yesterday is optimal network design preventing contagion.
One of the consequences of financial market liberalisation is that it was easy for the US to export its toxic mortgages to other countries.
Losses in Europe are as large now or greater than in the US.
But it also means disturbances in one part of the system quickly transferring elsewhere.
Now in the design of electrical networks, people are aware of the dangers of interconnection.
That you have a shock in one part of the system and it can lead to a brownout in the whole system.
And so you have a variety of ways, of circuit breakers, of dividing the system.
And that raises an important research question - what is the optimal design of a financial network.
That you have advantages of diversification of risk, but you also have the disadvantages of contagion of problems across the system and this
I think is an important area of future research.
A second is designing financial instruments that better reflect information imperfections and the systematic irrationalities.
The fact is not only this episode is exposed that there are not only high levels of information asymmetries, a kind of word that my own
earlier work focused on, but also irrationalities and some of these irrationalities are systematic
and therefore can be studied and can be dealt with in a systematic way.
And that is in some sense an important part of modern behavioural economics and that leaves in turn to designing the appropriate mix of
financial institutions taking into account local information, the need for renegotiation.
And as an example the asymmetries of information created by securitization.
These are some of the parts of the research agenda on finance.
The area macroeconomics, in my mind, is one that is most fertile for future research, because what I think that this episode really shows is
that the kind of representative agent rational expectation models which have been the centre of so much of research in macroeconomics in the
last 25 years are simply not up to the task of understanding modern macroeconomies.
Not only are they not up to the task, those you have relied on those models have contributed to the nature of the problem.
So, it’s not just that they don’t help us to understand, using those models may make things worse.
So we need, for instance, to have models, macro models that include financial linkages recognise the role of institutions the roles of
banks, the consequences of redistributions, because that is what happened.
Massive redistributions are going on and the importance of information asymmetries, bubbles,
both of the rational herding kind and of the irrational kind that we have seen recently.
There is also a policy, I’m going to call it policy in research agenda directed at trying to improve our policy framework.
I began the discussion saying very clearly that markets in general are not constrained Pareto efficient.
What we have seen in a very dramatic way and we saw over and over again is unfettered financial markets do not work.
Almost no one believes in free banking.
For instance, the last experiment with free banking was Chile under the influence of Milton Friedman.
They’re still suffering, paying back the debt that they accrued 20 years ago in getting
the country out of the mess that that experiment lead to.
Well, no one’s gone that far free banking but there has been strong move to deregulation.
Now the issue is not regulation versus deregulation.
The issue is really the right kind of regulatory framework, design the right kind of regulatory framework, and we clearly did not have the
right kind of regulatory framework.
So, what we’ve seen is that the regulation that we had and the regulatory institutions that we have failed, so we need both better design of
the regulations to discourage the destructive behaviours that we’ve seen, but also to encourage financial systems to fulfil their core
mission including designing products that help individuals manage the risk which they face better.
And I note here that I’m not sure that all this can just be done just with regulation.
There may need to be more extensive intervention in markets.
So, we need better regulations, but we also need a design of better regulatory institutions and here the research agenda needs to begin by
re-examining the whole theory of regulatory capture which I think is badly flawed.
It captures a grain of what goes on, but only a grain.
We need a theory of regulation that is better than the simplistic capture theory and this itself should be an important subject of study.
In conclusion our financial system failed in its core missions - allocating capital and managing risk.
A massive misallocation of capital and clearly institutions that were supposed to manage risk created risk.
The consequences for economy have been enormous, but there also large social consequences.
The economic consequences can be measured in terms of the disparity between potential and actual GDP.
The potential GDP is growing to 3%, 3.5 %.
Our actual GDP has been growing at 1%, 1.5 %.
It’s likely to continue at that level for another year, year and half.
If you just look at that difference and you extrapolate it over 2-3 years we’re talking about 1.5 trillion dollars.
A lot more than the cost of a few regulators.
So, clearly our society is facing very large costs because of these failures in regulation and that’s not even to take into account the cost
to countries elsewhere in the world; the costs that will be borne in future years,
if you believe that there is unit roots in the growth process.
The bottom line then is that we must do better.
And a successful research agenda on the lines I’ve tried to lay out I think will help us to do just that.
Thank You.