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«Towards a General Theory of Deep Downturns» 
Joseph E. Stiglitz

16 See Stiglitz and Yun (2005, 2013, 2014) for a more extensive discussion of the limits on the ability of insurance and loans to achieve full interstate and intertemporal smoothing.

17 Of course, in the absence of uncertainty, there is nothing to learn. With uncertainty, there is, in principle, something that could be learned (e.g. forming better estimates of future variables), but the possibility of such learning is excluded by assumption from the analysis.

18 One of the peculiar aspects of these models is that if they were true then market socialism would have worked. (See Stiglitz 1994.)

19 There are models, of course, with costly search, where there can be frictional unemployment. This lecture is concerned with deep downturns, where the level of unemployment goes well beyond that which can be described by search frictions. As we explain later, there are other labor market frictions which are relevant.

20 Those firms that are in the process of setting wages and prices do so knowing that they will not be able to adjust them for a certain length of time, and hence have to take into account economic conditions in those future periods. Thus, if the economy is adjusting towards eliminating unemployment through lowering wages and prices, this induces those firms able to adjust to lower them more than they would if they were maximizing profits only looking at current wages and prices.

21 See the works listed in the references. Two articles providing a broad survey of our perspective are Greenwald and Stiglitz (1988b and 1993b). See also Greenwald and Stiglitz (2003a).

22 As we explain below, this argument even applies to disinflation—lower rates of wage and price inflation than were anticipated. For then, the firm’s balance sheet will be weaker than it was anticipated to be.

23 On credit rationing with and without endogenous collateral constraints, see, for instance, Stiglitz and Weiss (1981, 1983, 1986); on equity rationing, see Greenwald, Stiglitz, and Weiss, 1984 and Maljuf and Myers, 1984; on other implications of imperfect information for finance, see Stiglitz, 1982; on costly state verification, see Townsend, 1979; on the role of bankruptcy, see, e.g. Stiglitz (1969, 1972), Hellwig, 1977, and Greenwald and Stiglitz (2003); and on debt enforcement, see Eaton and Gersovitz 1981 and Eaton 1986.

24 Firms may act in a risk averse manner for other reasons: managers’ long term compensation depends on how well the firm that they are managing does; they cannot fully diversify out of this risk. See Greenwald and Stiglitz (1990a) and Stiglitz (1982).

25 See, in particular, Koo (2011).

26 Earlier, Eisenberg and Noe (2001) provided a solution without bankruptcy.

27 This is part of the missing capital that helps explain why, after a crisis, GDP remains well below the pre-crisis trend line. See Stiglitz (2015c).

28 Greenwald and Stiglitz (2003) emphasized this.

29 The purpose of our 2003 book was to provide such a theory.

30 Financial markets thought that they had found a good solution to the moral hazard problem that arises when the parties originating mortgages and packaging them differ from those who ultimately hold the assets: the originators and the investment banks that put together the securitization packages made warranties and representations concerning the mortgages; any mortgage that was not as represented could be put back to the originator and/or investment bank. In the aftermath of the crisis, it became evident that there was widespread fraud, and the originators and investment banks refused to honor the contract. In some cases, after very expensive litigation, they were forced to do so by the Courts. These critical aspects of markets are not embraced by the standard models.

31 For early discussions of bankruptcy cascades—how the failure of one firm can lead to that of others—see Allen and Gale, 2000 and Greenwald and Stiglitz, 2003. On optimal diversification, trend reinforcement, the design of credit networks, and the potential desirability of credit controls, see Stiglitz (2010a, 2010b) and Battiston et al 2007, 2012a, 2012b, 2013; Gallegati et al 2008; Haldane (2009) and Haldane and May (2010).

32 This includes work on sunspot equilibrium.

33 See the earlier discussion in the context of securitization. In a sense, it is hard to reconcile fraud with rational expectations: if there were even a small expectation of such fraud, individuals and firms would not have entered into the contracts. See Greenwald and Stiglitz (1992). Kindleberger (1978) notes that similar problems occurred in many of the other bubbles.

34 See, for instance, Ariely (2010).

35 See also Greenwald, Stiglitz, and Weiss (1984).

36 Even Greenspan did not seem to understand the basic principles of the allocation of risk. See Stiglitz (2010).

37 There is a large literature on efficiency wages, dating back to Stiglitz (1974) and Shapiro and Stiglitz (1984).

38 Explained in part by uncertainty and risk aversion (Greenwald and Stiglitz, 1989).

39 Moreover, differences in the processes governing price adjustments in different sectors in a decentralized economy can give rise to significant allocative distortions. See Stiglitz (1999).

40 More generally, fixed and especially sunk costs of hiring workers also can give rise to real rigidities in labor markets, leading to unemployment. See Greenwald and Stiglitz (1987b, 1995).

41 More generally, it can be shown that it is easy to have bubbles consistent with short run rational expectations so long as there are not futures markets going out infinitely far into the future (which there obviously were not), or equivalently, so long as there is not perfect foresight extending infinitely far into the future. See Hahn (1966) and Shell and Stiglitz (1967).

42 If, of course, a crisis had been widely expected (at some earlier date), then consumption would have fallen at that earlier date—and the downturn would have occurred at that earlier date.

43 See the earlier comments on variable rate mortgages and the references cited there.

44 There are also some models which introduce demand shocks of another kind (Lorenzoni, 2006, 2011). Consumers’ and firms’ expectations are based on noisy public sources of information (a public signal). The noise component in this signal (i.e. the “news shock”) causes aggregate mistakes in agents’ expectations about productivity. These mistakes lead to deviations of output from its natural level, which have the typical features of aggregate demand shocks. But underlying the analysis is a technology shock, on which is overlaid imperfect information. It is not plausible that such demand shocks played an important role in recent fluctuations: as expectations of increased productivity grew in the late 90’s, there was not a boom in demand, except for that produced by the housing bubble; and the slowdown of productivity has not had the converse effect.

45 This is a critique that can be levied against some variants of the Alternative New Keynesian models. Some of the Greenwald-Stiglitz models, for instance, focus on the role that financial market frictions in the presence of perfect wage and price flexibility generate employment fluctuations.

46 It may, for instance, be related to the deep structural transformations described earlier in this paper. In that case, it is a large change in technology that is the driver of the downturn, not an underlying problem in the financial sector.

47 They explain why the bank lending rate is not just the risk-adjusted T-bill rate.

48 For a more extensive discussion of these distributive issues, see Stiglitz (2015b).

49 For an excellent parallel discussion of how the alternative models led to flawed policy conclusions, see Mason and Jayadev (2013).

50 As seemed to be the case during the Great Depression. See Alex Field (2003, 2011).

51 This is especially so in the presence of real wage rigidities: in periods of high unemployment workers typically do not join the labor market, even if wages are slightly higher (though there is some literature suggesting that unemployment can, under some circumstances, elicit an even greater increase in labor supply as more family members struggle to find a job. See Basu et al 2002 and the references cited there. If there were a labor supply side effect, it could have a significant adverse effect on aggregate demand because of the adverse distributive effect.

52 Note, however, that if the creditors are constrained in their lending, e.g. by capital requirements, they can expect lending, and this effect could predominate.

53 Thus Eggertsson (2011) presents an elegant NK DSGE model with fixed prices in which he shows that labor tax cuts are contractionary in the presence of the ZLB. But while he calls it a “micro-founded” model, it is a very special model, in which Ricardian equivalence holds, there are no financial constraints, and individuals live infinitely long. While he uses the Dixit-Stiglitz model, a key feature of that model is monopolistic competition with constant elasticity demand curves, an implication of which is that prices (net of taxes) are a fixed mark-up over costs (gross of taxes). And yet, as he says, in the model “An important assumption is the price the firm sets is exclusive of the sales tax.” (p. 66-67). Moreover, while there may be a normal process of price adjustment (in a Calvo type model), it seems arbitrary to assume that the pattern of price adjustments either for a once and for all or a one-time tax change would be the same as that for those induced by other changes in factor costs or demand.

54 To avoid these important distributive effects, most of the NK representative agent literature assumes that foreigners lend but do not invest, an assumption which is increasingly unrealistic in our globalized economy.

55 This part of the lecture draws heavily upon Greenwald and Stiglitz (2003).

56 This is formalizes Dennis Robertson’s theory of loanable funds as the basis of the determination of the interest rate.

57 More precisely, because all depositors in the bank benefit, the costs of this monitoring should be borne by these depositors.

58 They can (and have) also arise from sudden changes in policy.

59 These effects are not picked up at all in the standard DSGE models.

60 I should qualify this: most of the standard monetary economics simply assumes the ability of monetary authorities to do this. It does not actually model bank behavior.

61 Recall our earlier discussion, where we noted that Keynes’ analysis was based on the assumption of a horizontal demand curve for money. Nor does it have anything to do with the zero lower bound to the nominal interest rate

which has received so much attention as of late. As we explained earlier, it is implausible that simply by lowering the real interest rate from minus two percent to say minus four percent, the economy will be restored to full employment. Earlier, we explained why aggregate demand might not be very sensitive to changes in real interest rates. (See Greenwald and Stiglitz, 2003, for a discussion of both the theory and evidence.)

62 The payment of such bonuses needs, of course, to be modeled. It is a reflection of corporate governance problems that are pervasive in the corporate sector, but appear especially prominent within the financial sector.

63 The current system relies heavily on warranties and representations by the private sector that the mortgages that they have originated are as they say they are. The crisis revealed massive fraud on the part of the originators and massive breaking of contracts. To enforce contracts, the government has had to pay huge litigation costs. Direct public lending would avoid these problems.

64 This was one of the main arguments put forward for government income contingent loans. See, e.g. Stiglitz (2015).

65 Friedman (1969).

66 For a more extensive discussion of this point, see Greenwald and Stiglitz, 1987a.




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