Stiglitz: Old economic models failed us

Needed: a new economic paradigm

By Joseph Stiglitz
August 19, 2010 | Financial Times

The blame game continues over who is responsible for the worst recession since the Great Depression – the financiers who did such a bad job of managing risk or the regulators who failed to stop them. But the economics profession bears more than a little culpability. It provided the models that gave comfort to regulators that markets could be self-regulated; that they were efficient and self-correcting. The efficient markets hypothesis – the notion that market prices fully revealed all the relevant information – ruled the day. Today, not only is our economy in a shambles but so too is the economic paradigm that predominated in the years before the crisis – or at least it should be.

It is hard for non-economists to understand how peculiar the predominant macroeconomic models were. Many assumed demand had to equal supply – and that meant there could be no unemployment. (Right now a lot of people are just enjoying an extra dose of leisure; why they are unhappy is a matter for psychiatry, not economics.) Many used "representative agent models" – all individuals were assumed to be identical, and this meant there could be no meaningful financial markets (who would be lending money to whom?). Information asymmetries, the cornerstone of modern economics, also had no place: they could arise only if individuals suffered from acute schizophrenia, an assumption incompatible with another of the favoured assumptions, full rationality.

Bad models lead to bad policy: central banks, for instance, focused on the small economic inefficiencies arising from inflation, to the exclusion of the far, far greater inefficiencies arising from dysfunctional financial markets and asset price bubbles. After all, their models said that financial markets were always efficient. Remarkably, standard macroeconomic models did not even incorporate adequate analyses of banks. No wonder former Federal Reserve chairman Alan Greenspan, in his famous mea culpa, could express his surprise that banks did not do a better job at risk management. The real surprise was his surprise: even a cursory look at the perverse incentives confronting banks and their managers would have predicted short-sighted behaviour with excessive risk-taking.

The standard models should be graded on their predictive ability – and especially their ability to predict in circumstances that matter. Increasing the accuracy of forecast in normal times (knowing whether the economy will grow at 2.4 per cent or 2.5 per cent) is far less important than knowing the risk of a major recession. In this the models failed miserably, and the predictions of policymakers based on them have, by now, totally undermined their credibility. Policymakers did not see the crisis coming, said its effects were contained after the bubble burst, and thought the consequences would be far more short-lived and less severe than they have been.

Fortunately, while much of the mainstream focused on these flawed models, numerous researchers were engaged in developing alternative approaches. Economic theory had already shown that many of the central conclusions of the standard model were not robust – that is, small changes in assumptions led to large changes in conclusions. Even small information asymmetries, or imperfections in risk markets, meant that markets were not efficient. Celebrated results, such as Adam Smith's invisible hand, did not hold; the invisible hand was invisible because it was not there. Few today would argue that bank managers, in their pursuit of their self-interest, had promoted the well-being of the global economy.

Monetary policy affects the economy through the availability of credit – and the terms on which it is made available, especially to small- and medium-sized enterprises. Understanding this requires us to analyse banks and their interaction with the shadow banking sector. The spread between the Treasury bill rate and lending rates can change markedly. With a few exceptions, most central banks paid little attention to systemic risk and the risks posed by credit interlinkages. Years before the crisis, a few researchers focused on these issues, including the possibility of the bankruptcy cascades that were to play out in such an important way in the crisis. This is an example of the importance of modelling carefully complex interactions among economic agents (households, companies, banks) – interactions that cannot be studied in models in which everyone is assumed to be the same. Even the sacrosanct assumption of rationality has been attacked: there are systemic deviations from rationality and consequences for macroeconomic behaviour that need to be explored.

Changing paradigms is not easy. Too many have invested too much in the wrong models. Like the Ptolemaic attempts to preserve earth-centric views of the universe, there will be heroic efforts to add complexities and refinements to the standard paradigm. The resulting models will be an improvement and policies based on them may do better, but they too are likely to fail. Nothing less than a paradigm shift will do.

But a new paradigm, I believe, is within our grasp: the intellectual building blocks are there and the Institute for New Economic Thinking is providing a framework for bringing the diverse group of scholars striving to create this new paradigm together. What is at stake, of course, is more than just the credibility of the economics profession or that of the policymakers who rely on their ideas: it is the stability and prosperity of our economies.

The writer, recipient of the 2001 Nobel Memorial Prize in economics, is University Professor at Columbia University. He served as chairman of President Bill Clinton's Council of Economic Advisers and as chief economist of the World Bank. He is on the Advisory Board of INET

Lenzner: $12-Trillion Lessons From Saving Wall St.

Twelve-Trillion-Dollar Lessons From Saving The Fat Cats

By Robert Lenzner

December 15, 2009 | Forbes.com

When you add up all of the direct and indirect costs, saving Wall Street was a task that required an amount of money almost equal to the value of the entire U.S. economy. It cost $12 trillion to prevent the massive failure of the financial system. A fraction of that amount stabilized Detroit's automobile industry.

This $12 trillion package gifted a goldmine to Goldman Sachs and JPMorgan Chase while granting Citigroup, AIG, Bank of America and Wells Fargo time to come back from the precipice for renewed fortune hunting. Washington public policy transferred an agglomeration of wealth so magnificent that one investment banker in a high position likened it to the way Putin transferred Russia's wealth to a handful of oligarchs.

Investors in the nation's financial institutions can thank this massive bailout for the astonishing recovery in financial shares: Goldman Sachs has more than tripled from its low, and Morgan Stanley has more than doubled. Bank of America shares are worth six times what they were at the bottom, and even Citigroup is a quadruple, going from 97 cents to around $4.

This leads us to a powerful lesson from the last year: A steep and painful bear market meltdown is followed by a sharp, upward spike in stock prices. It happened in the 1930s, and coming out of the 1973-1974 bear market, and it happened this past year.

This lesson in boomerangs is still hard to absorb. How else to explain how the Dow Jones industrial average came back from its low of 6,500 in March 2009 to a peak of 10,600 this fall. The lesson learned by savvy market strategist and Forbes columnist Ken Fisher, CEO of Fisher Investments, is this: "Just about the time you think that everything you ever thought no longer works, it all starts to work perfectly again."

Classic end of bear-market behavior becomes classic bull-market behavior--sounds simple, doesn't it? But how many investors really thought it was a credible reaction to 2008. Not many. They didn't listen to how money talks, trillions of dollars of it.

Another lesson we learned was that markets around the globe trade in tandem with each other. China and other emerging markets were more devastated than the U.S. during the meltdown because of panic selling by hedge funds, but these markets rebounded simultaneously and with even more forcefulness than we saw in U.S. stocks.

Many asset classes also traded in parallel patterns, as commodities and stocks moved together, tough at not precisely the same pace. Some nations' economies grow more dynamically, like China at an 8% annualized pace, compared with 2% in the U.S.

We also learned monetary lessons, like deflation is a greater risk than inflation. We learned to expect continued cheap and easy money until there are signs the economy has strengthened and the unemployment rate is declining.

We are still suffering from excess capacity, a high inventory of housing and cautious consumers.

Individual investors are still scared and risk-averse. There is an enormous amount of cash on the sidelines earning zip. Investors are selling equity mutual funds and seeking the relative safety of fixed-income funds. Treasury financings are oversubscribed, despite interest rates as low as they were in the 1950s.

Gold and the dollar trade in an inverse relationship to each other 80% of the time, so if you believe the dollar is doomed to be weak, you can confidently bet on the upward slope of gold. Gold is up 30% in 2009 while the dollar has declined, on average, 16% against other world currencies. You can also bet on the price of oil and copper rallying when gold rises and the dollar falls. For the moment, the dollar is rallying, which acts to push gold, oil and copper down.

A final lesson, or perhaps admonition, is that Goldman Sachs is getting too smug, arrogant and selfish for its own good. It is intending to spend about 50% of its net revenues on bonuses, come hell or high water. That's $20 billion, more or less. It doesn't change the magnitude of the wealth transfer if the top 30 Goldman executives will not get cash but stock over a five-year period. This will set off a firestorm across the nation.

Goldman is awash in money because Bear Stearns and Lehman are no more, and Citi, Bank of America, Wells Fargo and Morgan Stanley--not to speak of several European financial giants--have been wounded. Goldman's largesse to its employees is a function of immensely reduced competition. Let's see if Goldman can maintain its advantage.

Stiglitz, et al: 'Deflation a threat right now'

Unfortunately, so many people have been programmed to fear inflation as the worst possible thing in the world, that they see the threat of distant inflation even in the midst of present deflation.

Take note: the U.S. consumer price index has fallen for six straight months compared to the same months last year. This is the longest period of U.S. price drops since 1954-55. Retailers like Kroger and Wal-Mart have told analysts openly: their businesses are suffering from deflation.

And core inflation (a measure of inflation that excludes volatile markets like oil and food) in the U.S. could soon be zero percent.

Yes, the Fed is printing more money, but the M2 money supply has shrunk 1 percent since mid-June 2009.

As wages shrink, debts become bigger in real terms, meaning people consume even less, making for a vicious cycle of idle capacity, layoffs, wage cuts, and price deflation.

Stiglitz: Deflation Threat Pushes Fed to Stay at Zero

By Michael McKee

October 2, 2009 | Bloomberg

The U.S. faces the possibility of deflation for the first time since the Eisenhower administration, a threat that may prompt the Federal Reserve to keep interest rates near zero through next year.

Executives at Kroger Co., the largest U.S. supermarket chain, blamed deflation for a 7 percent drop in earnings in the second quarter, while falling prices for food, gasoline, and electronics left August sales unchanged at Costco Wholesale Corp. A sustained price drop might set off a chain reaction in which lower profits force employers to pare wages and payrolls. That would erode consumer demand, exacerbating wage cuts and firings.

Such a spiral led to Japan's "lost decade" of slow economic growth in the 1990s. A more vicious version in the U.S. helped create the Great Depression six decades earlier. Bond investors are forecasting retreating consumer prices, as shown by the yield they demand to hold a one-year bond versus a similar inflation-protected bond.

"Deflation is definitely a threat right now," Nobel laureate Joseph Stiglitz, 66, a professor at Columbia University in New York, said in a Sept. 22 interview. "The combination of the deflation threat and the sluggish recovery should keep the Fed on hold for quite a while."

Consumer prices are experiencing deflation, with the consumer price index sliding for six straight months from year- earlier levels, the longest stretch of declines since a 12-month drop from September 1954 to August 1955, according to the Labor Department.

So far, the core consumer-price index, which excludes food and energy, is facing disinflation, a slowing in the pace of increase. The core index rose 1.4 percent in August from a year earlier, down from 2.5 percent in September 2008.

Fed Trio

Regional Federal Reserve Bank Presidents Janet Yellen, of San Francisco, James Bullard, of St. Louis, Richard Fisher, of Dallas, and Charles Evans, of Chicago, have expressed concern in past weeks about the possibility of declining prices.

"Disinflationary winds are blowing with gale-force effect," Evans, 51, said in a Sept. 9 speech in New York.

While the economy contracted 2.7 percent during the 1953 recession, it shrank 3.8 percent in the current recession, the most since the 1930s. Economists at New York-based JPMorgan Chase & Co. and Goldman Sachs Group Inc., the second- and fifth- biggest U.S. banks by assets, say there's so much deflationary excess labor and plant capacity in the economy that the Fed won't raise interest rates until at least 2011.

Gross Pessimism

"The potential for a deflationary downdraft continues for several years" if economic growth doesn't accelerate, Bill Gross, who runs the world's biggest bond fund at Pacific Investment Management Co. in Newport Beach, California, said in a Sept. 29 interview with Bloomberg Radio.

At their most recent meeting on Sept. 23, Fed policy makers agreed to leave the benchmark interest rate in a range of zero to 0.25 percent, where it's been since December 2008.

Only 69.6 percent of the country's factories, utilities and mines were in use during August, close to the record low of 68.3 percent reached in June.

Former Fed Chairman Alan Greenspan said the economic rebound won't prevent a further slowing of the pace of price increases. "We are still, by any measure, in a disinflationary environment," Greenspan, 83, said in a Sept. 30 Bloomberg Television interview in Washington.

At the same time, recent reports on manufacturing, housing, and consumer spending suggest that any investor concerns about the danger of deflation are overblown, said Dean Maki, chief U.S. economist at Barclays Capital Inc. in New York.

Growth Outlook

The median projection of economists surveyed by Bloomberg News is for first quarter growth of just 2.4 percent, compared with a decline of 6.4 percent in the first quarter of 2009. Maki sees a 5 percent expansion in the first quarter of 2010.

That would translate into higher prices.

"Inflation is driven more by the level of demand and pace of growth than by the size of the output gap," said Stephen Stanley, chief economist at RBS Securities Inc. in Stamford, Connecticut. "As the economy returns to solid growth in 2010, we are quite confident that, in sharp contrast to the consensus Fed view, core inflation will be creeping higher."

Fed officials are already planning for that, and publicly discussing an exit strategy once the economy does pick up. At that point, the Fed may have to move with "greater force" than some anticipate to keep inflation from accelerating too rapidly, Fed Governor Kevin Warsh, 39, said in a Sept. 25 speech in Chicago.

Fed Purchases

That day is far off for bond investors. Inflation fears, raised by the more than $1 trillion the Fed has pumped into the economy by lowering rates and buying Treasuries and mortgage- backed securities, are fading.

"There's been a significant flattening on the long end of the curve," reflecting concern about deflation, said Pacific Investment's Gross, 65, who is buying longer-maturity Treasuries in response. The yield on the 10-year note, which was 3.95 percent on June 10, was 3.18 percent at the close of New York trading yesterday. The difference in yield between nominal and inflation-protected Treasury securities maturing in one year is negative 0.4 percent, suggesting investors expect deflation during the next 12 months. Over five years, that inflation premium is now 1.21 percent, down from 1.86 percent on June 10.

The Fed needs to "keep inflation expectations from slipping to undesirably low levels in order to prevent unwanted disinflation," Vice Chairman Donald Kohn, 66, said Sept. 10 in Washington during a speech at the Brookings Institution.

Oil Role

Falling consumer prices are partly a reflection of a 52 percent decline in oil prices to about $70 a barrel yesterday from $145.45 a barrel on July 3, 2008.

The slowing in core prices is more of a concern, said Michael Feroli, an economist at JPMorgan. The core rate fell following three prior recessions in which unemployment rose above 7 percent. That "suggests that core inflation could well be below zero within two years," Feroli said in an interview.

Core CPI fell 5.3 percent following the recession of 1973- 1975, 10.7 percent following the recession of 1981-1982 and 3 percent following the recession of 1990-1991.

Unemployment rose to 9.8 percent in September, a Labor Department report showed today, and it will likely climb to 10 percent in the fourth quarter, according to the Bloomberg survey of economists. The jobless rate was estimated to average 8.8 percent in 2011.

With unemployment elevated, companies may not need to raise pay to attract workers, even when the economy picks up.

'Enormous Slack'

"My personal belief is that the more significant threat to price stability over the next several years stems from the disinflationary forces unleashed by the enormous slack in the economy," Yellen, 63, said Sept. 14 in San Francisco.

Wages for U.S. workers fell for eight months in a row, dropping 5.6 percent from October 2008 to June 2009, according to Commerce Department figures. In contrast, wages continued to grow in the 1954-1955 deflation period.

Stagnating wages and fading job prospects are sapping demand. Consumer spending may increase in the fourth quarter by just 1 percent and in 2010 by an average of only 1.6 percent, according to the median estimate in the Bloomberg survey of economists.

Consumption rose by an average 5.7 percent a quarter in the five years before the recession began in December 2007.

"A weak labor market in a competitive environment puts downward pressure on wages," said Stiglitz, who won the Nobel prize for economics in 2001. "So, the possibility of another actual decline in wages cannot be ruled out."

Declining Incomes

The deflation danger is compounded by household debt, said Paul Ashworth, senior U.S. economist at the consulting firm Capital Economics in Toronto. U.S. homeowners owed $13.9 trillion in the third quarter of 2008, compared with an average of $8.5 trillion in the 57 years the Fed has kept records.

"As incomes start to fall, that debt gets bigger in real terms: You have a smaller income to pay off that debt," Ashworth said. "Deflation combined with high indebtedness can be very problematic."

Inflation happens when too much money chases too few goods. Gary Shilling, president of the investment research firm A. Gary Shilling & Co. of Springfield, New Jersey, said that even as the Fed continues to pump money into the economy, the money supply, as measured by the central bank's M2 index, has dropped 1 percent since mid-June.

"Look what is happening to money supply, it is actually contracting now when supposedly the economy is picking up," Shilling said in an interview on Bloomberg Television Sept. 21. The economy is facing deflation "because you've got basically an excess-supply world," he said.

Profits Dwindling

Profits have evaporated as companies lose pricing power. The 419 non-financial firms in the S&P 500 reported earnings down 28 percent in the quarter ending June 30. Analysts surveyed by Bloomberg anticipate a 30 percent decline for the third quarter, which ended this week.

"Businesses trying to sell products and services feel they are pushing on a string and are adjusting their behavior accordingly," Fisher, 60, the Dallas Fed president, said in a Sept. 3 speech at the University of California in Santa Barbara. "They are cutting prices."

Rodney McMullen, president of Cincinnati-based Kroger, blamed price reductions for second-quarter earnings that fell 10.5 percent short of analysts'estimates.

"We certainly sold more units. But lower retail prices and profit per unit pressured" results, McMullen told analysts in a Sept. 15 conference call. "We began to see deflation."

The average amount spent per transaction in August at Issaquah, Washington-based Costco was about 7 percent below last year, Bob Nelson, vice president for financial planning, said on a Sept. 3 conference call with investors.

At Wal-Mart Stores Inc., the world's largest retailer, "headwinds" from deflation were in part responsible for a 1.4 percent drop in second-quarter revenue to $100.9 billion, chief financial officer Thomas Schoewe told analysts Aug. 13.