- Information asymmetries, imperfect information
- Making decisions based on imperfect information.
- Chief Economist of the World Bank
- Chairman of the Council of Economic Advisers
Joseph E. Stiglitz is a recipient of the Nobel Memorial Prize in Economic Sciences:
The notion that every well educated person would have a mastery of at least the basic elements of the humanities, sciences, and social sciences is a far cry from the specialized education.
A history class helped shape his thinking about globalization more than three decades later; he felt he was in a better position to think about the current episode from an historical perspective, and see it more through the eyes of the other side.
There was an irresistible attraction of economics. He studied both micro-economics and macro-economics.
Understanding of how markets work, an inquiry into whether planning provided an alternative.
He wanted it all, and economics seemed to have it all.
His conviction that if one attains positions of “power” one should view them as opportunities for social change also manifested itself.
It was the hey-day of MIT with first-rate professors (I had at least four Nobel Prize winners as professor: Samuelson (Nobel Laureate), Solow (Nobel Laureate), Modigliani (Nobel Laureate), and Arrow (Nobel Laureate).
Growth theory was then all the rage, and we did growth theory.
Economists tend to move in particular circles, defined by their “school” and “subject.”
Endogenous growth theory.
The cross fertilization was highly productive.
This was particularly the case in macro-economics, where in the 70s and 80s, the reining paradigms were either rational expectations / representative agent models or fixed price new Keynesian models.
The models that Stiglitz formulated, focusing on imperfect capital markets, risk averse, credit constrained firms, in which concerns about bankruptcy often play an important role, became widely accepted after similar ideas were picked up by the members of the macro-fraternity.
Keynes, who had revolutionized economics. Lord Kahn, of the Kahn multiplier (which explained how a dollar of government expenditure had a multiple effect in increasing GDP.
A sense of excitement that was associated not just with the generation of new ideas, but with the belief that those ideas were important, and not just for economics, but for society more broadly.
A sense of a community of scholars trying to understand some very important and complex problems.
His research in this period centered around growth, technical change, and income distribution, both how growth affected the distribution of income and how the distribution of income affected growth.
The most important paper to emerge from his thesis, “The Distribution of Income and Wealth Among Individuals.
The subject of the causes and consequences of inequality has remained one of his abiding concerns, one which he pursued as he began to delve into the economics of information.
The overall success of some of his research program, was a source of unending frustration.
Once he undertook the analysis of a problem, he often looked at it from a variety of perspectives. He approached the problem as a series of thought experiments – unlike many other sciences, we typically cannot do actual experiments. He would construct models changing one assumption or the other.
Each would provide some insight into what drove the results. The whole was more than the sum of the parts; while each of the models was, by itself, of some interest, it was the collection of models, and how the results depended on the particular assumptions employed, which provided the greatest insight.
His original work thus grew into a monograph of some hundred pages.
Exploring the behavior of the firm under uncertainty, and in particular, the consequences of risk with an incomplete set of risk markets
The exploration of “Alternative theories of wage determination and unemployment in less developing countries.
Another project that he began concerned the interaction between the distribution of income and short run macro economic behavior.
At the time, most macro economic models simply assumed that wages and prices were fixed.
During the great depression wages and prices had fallen considerably. The problem was not that they were absolutely fixed, but with the dynamics of adjustment. He explored these dynamics, to explain the persistence of unemployment. He showed how such dynamics can give rise to cyclical behavior.
During this period, he continued his work on economic dynamics, and began my research on the economics of uncertainty, which in turn, quickly led to the work on the economics of information.
He showed that a competitive economy with futures markets extending an arbitrarily large finite number of periods into the future would, in general, exhibit dynamic instabilities; that is, it would take off onto a path that appeared to be efficient and stable, with the inefficiency and instability only manifesting itself some distance into the future.
The subject was central to the on-going debate concerning the efficiency of the capitalist economy.
If stability and efficiency required that there existed markets that extended infinitely far into the future – and these markets clearly did not exist – what assurance do we have of the stability and efficiency of the capitalist system?
In one important variant on this theme, he assumed that there were rational expectations. Simplistic representative agent models living infinitely long had been constructed, and, not surprisingly, in these models, the problems of instability and inefficiency did not arise.
He assumed, on the contrary, that individuals were finitely lived; there were overlapping generations. In that case, there were an infinite number of paths consistent with rational expectations extending infinitely far into the future.
In some cases, some individuals are better off in one equilibrium, some worse off, but in other cases, one equilibrium could Pareto dominate others.
Much of his work in this period was concerned with exploring the logic of economic models, but also with attempting to reconcile the models with every day observation.
Thus, in much of his earlier work he began by asking what would happen to the standard results if there were not the complete set of risk markets, analysis of competitive equilibrium.
His research posed problems for which there was no obvious answer: what should (or do) firms maximize?
The discrepancies between the kind of behavior implied by the standard model and actual behavior also became increasingly clear.
In the standard model, the only risk that firms should worry about was the correlation of the outcomes (profits) with the “market”; in practice, businesses seem to pay less attention to that than they do to “own” risk, the chance the project will succeed or fail.
In the standard model, everyone agrees about what the firm should do; in practice, there are often heated disagreements.
Persuasive theory of the firm had to be consistent with these, and other, aspects of widely observed firm behavior.
The most important result in the economics of uncertainty in the 1950s was that of Modigliani and Miller (Nobel Laureate), who argued that corporate financial structure – whether firms finance themselves with debt or equity – made no difference (other than as a result of taxes).
What was interesting about the theory was that it was based on assumptions of rational behavior, and yet if it were true, there was ample evidence of market irrationality – the thousands of people on
Wall Street and other financial centers who seemed to be worrying about corporate finance – and for reasons that had nothing to do with taxation.
He began his analysis of corporate finance by demonstrating that the result was far more general than they had shown.
There were two assumptions that they had ignored, and these turned out to be crucial: they had assumed no bankruptcy and perfect (or at least symmetric) information.
He explored the consequences of these assumptions, not only for the theories of corporate finance, but also for corporate governance (including takeovers) and macro-economics.
As he noted in his prize lecture, the failure of the IMF to take on board fully the consequences of these assumptions played an important role in their policy failures.
His work on the economics of uncertainty led naturally to the work on information asymmetries, and more generally, imperfect information.
In the work on the economics of uncertainty, he explored the consequences, given beliefs about probability distributions, say, of prices and outputs, of economic behavior.
The standard theory not only had assumed that there was a complete set of markets for these risks, but that beliefs about these probability distributions were exogenous, unaffected by any actions.
Individuals and firms spend an enormous amount of resources acquiring information, which affects their beliefs; and actions of others too affect their beliefs.
As he approached the problems that are today referred to as the economics of information, he was greatly helped by the breadth of his education.
The problem of how people form their beliefs is, of course, the central question of statistics: making inferences on the basis of limited data.
Concerned with using probability theory to make statistical inferences (rather than “classical” statistics).
He helped shift the sub discipline to focus more broadly on the economics of the public sector.
He noted in my Nobel lecture, an early insight in his work on the economics of information concerned the problem of appropriability – the difficulty that those who pay for information have in getting returns.
This is, of course, the central concern of public goods, one of the main subjects within the economics of the public sector.
He recognized that information was, in many respects, like a public good, and it was this insight that made it clear to him that it was unlikely that the private market would provide efficient resource allocations whenever information was endogenous.
Subsequent work was trying to define more precisely the nature of the market failures.
He explained in his Nobel lecture, the time he spent in Kenya was pivotal in the development of his ideas on the economics of information.
He thinks in part the reason is that seeing an economy that is, in many ways, quite different from the one grows up in, helps crystallize issues: in one’s own environment, one takes too much for granted, without asking why things are the way they are.
As he studied development, he was forced to think everything through from first principles.
He had grown up in a world in which everyone was a sharecropper, he probably would have accepted this as the way things are. As it was, sharecropping seemed like a peculiar institution, for it seemed to attenuate greatly the incentives workers had to work (since they typically had to give one out of two dollars that they earned to the landlord).
Articles that argued that in competitive equilibrium, there could not be discrimination, so long as there are some non-discriminatory individuals or firms, since it would pay any such firm to hire the lower wage discriminated – against individuals, and take them seriously.
He knew that discrimination existed, even though there were many individuals who were not prejudiced.
The theorem simply proved that one or more of the assumptions that went into the theory was wrong; his task, as a theorist, was to figure out which assumptions were the critical ones.
Economics seemed to provide the tools with which one could analyze these alternative economic systems.
A central question was how, and how well, alternative systems addressed the problems of gathering, analyzing, and disseminating information, and making decisions based on imperfect information.
Understanding the limitations of the market – the so-called market failures – became one of the central foci of his research. He recognized that the standard model was deficient not only in its assumptions about information, but also in ignoring technical change. The latter he thought particularly curious, given the importance that technical change clearly played in our economy.
He showed that a monopoly, once established, could be persistent, that Schumpeterian competition was not, in general, “efficient,” and that in particular the incumbent could / would take actions which deterred entry, that potential competition would not in general suffice to ensure a rapid (efficient) pace of innovation.
These ideas are, of course, of particular relevance in the “new economy,” which centers around innovation.
He was interested in evaluating evolutionary processes. What could one say about whether free markets, by themselves, led to “efficient” or “desirable” evolution?
Were there interventions in the market which might “shape” evolution in ways which would lead to better outcomes?
Preliminary results suggest strongly the limitations of unfettered free market evolution.
(Part, but only part, of the problem lies with imperfections of capital markets.)
With the collapse of the Soviet system, and the recognition of the problems of socialism more broadly, he re-thought the lessons that might be gleaned from the failed experiment.
He came to the conclusion that the failure of the socialist economies reinforced his belief in the inadequacy of the competitive equilibrium model.
If that model had been correct, market socialism probably could have succeeded. The standard competitive market equilibrium model had failed to recognize the complexity of the information problem facing the economy – just as the socialists had. Their view of decentralization was similarly oversimplified.
Here, our concern was not with asymmetries of information or incentives, but with how different economic organizational structures in effect aggregated the disparate and limited information of different individuals.
As the former socialist economies decided to make the transition to a market economy, a host of fascinating problems was posed on how best to make that transition.
China provided the first venue for looking at these questions, in a series of meetings in 1980s, and Russia and the other countries of the former Soviet Union and Eastern Europe provide a second.
The debates were heated. Much was at stake. And underlying the debate were very different understandings of the fundamentals of a market economy – what was necessary to make it function.
His views on the inadequacy of the standard model played a central role in his thinking.
He emphasized the importance of competition, corporate governance, finance, and more broadly the institutional infrastructure. He did not place much stress on privatization.
He was part of a wider school, sometimes referred to as “gradualists,” as opposed to the shock therapists that focused on rapid transitions, with quick privatization.
The strategy for transition that he advocated was markedly different from that pushed by the IMF and the shock therapists.
The failures of so many countries to make a successful transition back to a market economy has provided new insights into what makes market economies function, one which he had occasion to explore during my years as the Chief Economist of the World Bank.
There is now a wide consensus on the importance of the institutional infrastructure, and on the dangers of rapid privatization.
He was convinced that there was an important role for government to play. One of the main questions with which he was concerned was how to redistribute income in a way as to minimize the loss in efficiency that is inevitably associated with tax distortions.
Economics of information had provided a framework within which this question could, for the first time, be addressed in a meaningful way.
Still another important strand of his research, only tangentially related to his work on the economics of information, concerned industrial organization.
Having constructed a model in which there are so many firms that each can ignore its impact on others’ economic actions, but still, firms face downward sloping demand curves – there is monopolistic competition.
This seemed to describe many of the markets in the economy far better than either the models of pure competition, pure monopoly, or oligopoly.
(Markets in which information is imperfect are also likely to be characterized by monopolist competition).
Being interested in constructing a general equilibrium model, within which one could assess how well the market functioned, in particular in making the tradeoffs between economies of scale and product diversity.
He showed that there was a single borderline case – of immense simplicity – in which the market made that trade-off perfectly; but more generally, it did not.
While his work on industrial organization and imperfect information undermined the confidence in the ability of unfettered markets to allocate resources efficiently, there was another strand of research in the economics profession which was trying to argue the contrary.
Those who argued that even with natural monopoly markets could be efficient; competition for the market could replace competition in the market; all that one required was potential competition.
On the face of it, this idea seemed suspect. If it were true, there would be no monopoly rents.
And indeed, his suspicions turned out to be true: He showed that even if there were arbitrarily small sunk costs (which there always are) then potential competition would not suffice to limit the abuses of monopoly.
The most important systemic failure associated with the market economy is the periodic episodes of underutilization of resources.
Trying to understand why the labor market does not clear – why there is persistent unemployment – has been another abiding concern, one which he has tried to approach from a variety of angles.
Even if wages fall, if prices fall too, real wages may not adjust very quickly.
The efficiency wage theories explains why it may pay firms to pay a wage higher than the market clearing wage: the increase in productivity more than offsets the increase in wages.
The theory of equity rationing helped explain why more “flexible” contractual arrangements were not adopted; such arrangements (such as those where wages depend on firm profitability) in effect make the worker have an implied equity stake in the firm, and, given asymmetries of information, the value which workers are willing to assign to such contractual provisions is less than that which is acceptable to the firm.
With rational expectations, government policy was ineffective, but that unemployment was not a serious problem. Neither of these conclusions made much sense to me; sought to show that the results depended not on the rational expectations assumption, but on the assumptions concerning wage and price flexibility.
Constructing a fixed wage/price model with rational expectations, and showed contrary to the suggestion of the rational expectations school, not only could unemployment be persistent, but that government policy was even more effective with rational expectations that without it
(i.e. multipliers associated with government expenditures were larger).
The reason was simple: an increase in government expenditures today had some spill overs to future periods.
Today’s increased savings translated into tomorrow’s increased income, and, with rational expectations, that increased income translated into higher consumption today.
Showing that there were multiple rational expectations equilibria: if everyone was pessimistic, then income would indeed be low today and tomorrow; but if everyone was optimistic, then both could be high.
Not just wage and price rigidities which could give rise to macro-economic problems. Incomplete contracts meant that unanticipated changes in wages and prices had large distributional effects, with correspondingly large consequences.
He thought it important to engage in issues of public policy.
His first major project was a direct outgrowth of work on imperfect information; it was concerned with the information externalities that arose in the process of oil exploration, externalities which played an important role in a heated dispute between the federal government and the states (which was eventually settled out of court for $12 billion).
How real markets work as well as the behavior of firms.
He was involved in two major public interest litigations, one concerning the treatment of Native Americans, the other with the exploitation of our natural resources.
Seneca Indians, gave him further insights into the nature of America’s past – and ongoing – exploitation of Native Americans. An unfair lease that had been imposed on the tribe was about to expire, and it insisted that it would renew only on more equitable terms.
He helped calculate the magnitude of the amount by which the previous lease had “cheated” them – magnitudes in excess of a billion dollars in present terms – and though the tribe was never compensated for these past injuries, the information he provided did, he thinks, contribute to a settlement which was far fairer than would otherwise have been the case.
In the 1980s, President Reagan tried to turn over as much of the offshore oil tracts to private companies as fast as he could – the fire sale was a give-away to the oil companies, depriving the American taxpayers of billions of dollars.
As Chairman of the Council of Economic Advisers, in which capacity he also served as a member of the cabinet.
The Council helps formulate economic policies for the Administration, and serves as a consultant for all the agencies in the government.
His span of responsibilities included not only macro-economics,
but policies in almost every sphere, from trade to anti-trust, from environment to agriculture, from energy to transportation, from welfare to health, from social security to taxation, from affirmative action, to tort reform.
He became deeply involved in environmental issues, which included serving on the International Panel for Climate Control, and helping draft a new law (including a new legal framework) for toxic wastes (which unfortunately never got passed).
He was pleased to see how ideas that he had helped formulate only a few years earlier, like adverse selection and moral hazard, were now part of the every day language of the policy debate in health care.
Perhaps his most important contribution in this period was helping define a new economic philosophy, a “third way,” which recognized the important, but limited, role of government, that unfettered markets often did not work well, but that government was not always able to correct the limitations of markets.
The research that he had been conducting over the preceding many years provided the intellectual foundations for this “third way.”
Work on information asymmetries emphasized the importance of incentives and the discrepancy between the incentives of government officials, and in particular professional politicians, and those who they are supposed to serve.
As a citizen-bureaucrat, the members of the council, who are typically drawn from academia and return to academia, have markedly different incentives than those of a professional politician.
Typically, the fact that our professional reputations as economists were at stake circumscribed what was said – we could not just be political hacks – and encouraged us to work for the adoption of economic policies that were consistent with economic principles.
When the President was re-elected, he asked him to continue to serve as Chairman of the Council of Economic Advisers for another term.
But he had already been approached by the World Bank, to be its senior vice president for development policy and its chief economist.
America’s economic policy had been successfully redefined, and the economy was performing well.
There were many problems yet to be addressed, such as putting social security on a sound financial footing.
The challenges and the opportunities in the developing world seemed far greater.
He had no strong agenda, other than doing what he could to promote the development of these countries, in ways which did as much as possible to eliminate poverty.
He described a trip to Ethiopia, where I saw the IMF advocate policies of financial market liberalization which made no sense, in which it argued that the countries budget was out of balance – when in his estimate that was clearly not the case – and in which it had suspended its program, in spite of that country’s first rate macro-economic performance.
More broadly, the IMF was advocating a set of policies which is generally referred to alternatively as the Washington consensus, the neo-liberal doctrines, or market fundamentalism, based on an incorrect understanding of economic theory as an inadequate interpretation of the historical data.
The IMF was using models that failed to incorporate the advances in economic theory, including the work on imperfect information and incomplete markets to which he had contributed.
Most importantly, they had departed from the mission for which they had been founded, under the intellectual guidance of Keynes – they actually promoted contractionary fiscal policies for countries facing an economic downturn – and they advocated polices like capital market liberalization, for which there was little evidence that growth was promoted, while there was ample evidence that such policies generated instability.
If the IMF had only pushed its views – misrepresenting them as the lessons of economic orthodoxy, describing them as if they were Pareto dominant (that is, they were policies which would make everyone better off, so that there were no trade-offs), rather than the policies which reflected the perspectives and interests of particular groups within society.
But all too often they used their economic power effectively to force countries to adopt these policies, undermining democratic processes.
IMF’s own governance was so dissonant with democratic principles (a single country has an effective veto; countries like China were long underrepresented, the “governors” of the IMF, those responsible for its decisions, finance ministers and the heads of the central banks, are hardly representative, and the heads of the central banks themselves are typically not directly democratically accountable).
With the East Asia crisis, his disagreements with the Fund came to a head.
The Fund’s policies seemed neither to accord with an understanding of the crisis countries and what he viewed as basic economics, especially as it had come to incorporate concerns about asymmetries of information and bankruptcy, corporate governance and finance, with which he had long been concerned. He argued against their prescriptions, and those within the World Bank broadly agreed.
He believed that there should be public discussion of such issues, he had few misgivings. He believed the public pressure that was generated did work; the counterproductive policies of excessive monetary and fiscal stringency were eased.
World Bank began its ten year review of the transition of the former Communist countries to the market.
The failures of the countries that had followed the IMF shock therapy policies – both in terms of the declines in GDP and increases in poverty -were even worse than the worst that most of its critics had envisioned at the onset of the transition.
There were clear links between the dismal performances and the particular policies that the IMF had advocated, such as the voucher privatization schemes and excessive monetary stringency.
Other failures were related to the inadequate attention given to issues of corporate governance (the importance of which had, for instance, been stressed in my earlier theoretical work.
Meanwhile, the success of a few countries that had followed quite different strategies suggested that there were alternatives that could have been followed.
Again, while the IMF defended its previous policies, he believed that the clear lessons that were drawn from these experiences did have some impact on policy prescriptions going forward.
The US Treasury had put enormous pressure on the World Bank to silence his criticisms of the policies which they and the IMF had pushed, and though the President of the World Bank agreed with the stances he took on most of the issues, he was, I think, less comfortable about open discourse of these issues.
He came to the World Bank under an agreement that he would be more than a corporate spokesperson, that he could speak out on the relevant issues, in a responsible way. He believed, in part, that the credence that would be given to what he said – and his ability to advance the development agenda – depended in part on the perception that he was expressing his views, not just repeating the institution’s official views.
Under Treasury pressure, it was impossible to maintain this kind of independence, which had been a hallmark of the World Bank’s research division, at least from the time that it achieved international prominence under the leadership of another.
He was, in any case, ready to return to academia – when President Clinton had asked him to be his adviser. The experiences during the seven years in Washington have helped shape his activities since then.
He helped found the Initiative for Policy Dialogue, with support of the Ford, Rockefeller, McArthur, and Mott Foundations and the Canadian and Swedish government, to enhance democratic processes for decision making in developing countries, to ensure that a broader range of alternative are on the table and more stakeholders are at the table.
This effort has enlisted the support of dozens of economics and other social scientists throughout the world, in a set of task forces that are intended to lay out alternative policy alternatives in a wide range of areas, and has conducted policy dialogues bringing together academics, government officials, NGO’s, labor leaders, and the press in a number of countries, including Serbia, Nigeria, Viet Nam, and the Philippines.
He has continued to take an active role advising governments on a broad range of issues, from the role of monetary policy under dollarization (Ecuador) to the reform of social security systems and second and third generation reforms in China, to the lessons that can be drawn from the past failures and successes for privatization, to the design of macro-economic responses to an economic slowdown.
He has continued to work actively to change the international economic arrangements, including the international institutions, to make them more transparent, to ensure that the policies that they have been pushing reflect the interests and concerns of the developing countries, and especially the poor within those countries, as well as the advances in economic science of the past quarter century.
He was pleased with the progress that has occurred: perspectives, such as greater reliance on bankruptcy and standstills, that I had long advocated have now either been adopted or are at the center of the policy debate.
But much remains to be done, and he anticipates that pushing this agenda will occupy much of my time in the years ahead.
The implications of information economics for macro-economics, and monetary theory in particular – He has turned more of his attention to an analysis of the role of information and incentives in political processes, as well as continuing his work on development more generally.
How to design policies which combine concerns for economic efficiency, social justice, individual responsibility, and liberal values.
Books by Joseph E. Stiglitz
- Price of Inequality
- Making Globalization Work
- Fair Trade for All
- Principles of Macroeconomics