In a paper by Joseph E. Stiglitz titled; "Towards a General Theory of Deep Downturns" [GenTheory], Joseph Stiglitz lays out what is right and what is wrong about most of current Neo-liberal (Friedmanista) and Neo-Keynesian (he calls it "New" Keynesian) thinking about current economics.
"deep downturns have marked capitalist economies since the beginning. It took enormous hubris to believe that the economic forces which had given rise to crises in the past were either not present, or had been tamed, through sound monetary and fiscal policy."
"Those who attempted to defend the failed economic models and the policies which were derived from them suggested that no model could (or should) predict well a “once in a hundred year flood.” But it was not just a hundred year flood—crises have become common. It was not just something that had happened to the economy. The crisis was man‐made—created by the economic system. Clearly, something is wrong with the models." [Stiglitz GT]
Why they are bad models?
He's more diplomatic than many of us would be. I call out most of these so-called economists as poseurs and con artists acting as front men for modern day scam artists. But he pretty much implied in his opening thesis:
"As it turned out, belief in those models actually contributed to the crisis. It was the assumption that markets were efficient and self‐regulating and that economic actors had the ability and incentives to manage their own risks that had led to the belief that self‐regulation was all that was required to ensure that the financial system worked well, and that there was no need to worry about a bubble. The idea that the economy could, through diversification, effectively eliminate risk contributed to complacency—even after it was evident that there had been a bubble. Indeed, even after the bubble broke, Bernanke could boast that the risks were contained"
In his paper he asks, explains and answers three questions:
- What is the source of large perturbations?
- How can we explain [the] magnitude of volatility?
- How do we explain persistence?
About midway through his Paper Joseph Stiglitz makes the statement:
"Deep downturns are a manifestation of deep and pervasive market failures—deviations from the standard competitive equilibrium model which underlies real business cycle theory. Markets fail in many ways, and the strand of New Keynesian model emphasizing nominal wage and price rigidity probably has identified one such market failure, but perhaps not the most important one. I have suggested that the alternative strand of New Keynesian models emphasizing financial sector imperfections may be more relevant, at least for deep downturns. Indeed, the third strand emphasizes that the central problem confronting economies facing deep slumps may not be price rigidities, but price flexibilities. The current worries about deflation are justified. Economies in which wages and prices are less flexible perform better."
in his paper he slams pretty much every trope of the Neo(he calls them new) Keynesians, Monetarists and pretty much everything Wall Street and so-called "modern" economists have been teaching in Economics since they threw out the "old Keynesian" textbooks in the 70s. He also revises a lot of things that seemed dogma before. If we don't come out with a better quality economics from the work of Stiglitz, Picketty and their countless cohorts of choir singers like me.
Joseph Stiglitz' latest paper packs so much information into it that as much as I want to do it justice. I can't translate it completely for laymen. I've tried to summarize major points. But ...
You can read the article here:
- In Chapter II He explains how the three strands of theory each stack up against reality and each other;
- Business cycles theory(and related work originating from Milton Friedman and his disciples);
- New (neo) Keynesian theories with rigid wages and prices;
- and his own alternative strands of New Keynesian economics, based on the work of Irving Fisher (1933) and Greenwald‐Stiglitz (himself).
- In that chapter he examines the faulty assumptions of Neo-Keynesian and Neo-liberal economic theories.
- Model Faulty Assumptions:
- No exogenous shocks (unexpected or unexplained externally caused events);
- perfectly flexible wages and prices, which means that all markets clear—there is, in particular, always full employment (though there may be variations in the hours worked);
- the perfectly flexible price system, together with inventories, dampens shocks (so that inventories are counter‐cyclical);
- all market participants have rational expectations; and there is common knowledge. There is, of course, still uncertainty; but there is no learning—in the way that learning is usually defined—and individuals have nothing to learn from each other. There are, of course, no betting markets—since individuals all agree about the probabilities of all events."
- "the economy is always in equilibrium" — Full equilibrium, with no unemployment versus reality
- "The Problematic Nature of the Representative Agent" — There is an inherent contradiction there.
Explaining What I can
Exogenous means external shocks; caused by crop failures, wars, embargoes, that sort of thing. The idea that market failure could cause failure wasn't even in the models.
Detailed list of his points:
Stiglitz lists the missing or distorted elements and examines each one:
He starts with some of the Friedmanista "Real business cycles" (and related work) ("1st generation DSGE models") (RBC):
The policy implications of these shocks should be obvious to anyone who observed them. Greenspan and other true believers in Friedman's economics were caught like Deer in headlights by the 2008 crisis. In Chapter II he simply refers to:
But in chapter IV. The crisis in economics. Stiglitz concludes his paper by summarizing why the two main orthodoxies of the past 35 years were bunkum. First he notes that the models not only didn't anticipate or predict the crisis of 2008 but:
"The 2008 crisis was not only a crisis in the economy, but it was also a crisis for economics—or at least that should have been the case. As we have noted, the standard models didn’t do very well. The criticism is not just that the models did not anticipate or predict the crisis (even shortly before it occurred); they did not contemplate the possibility of a crisis, or at least a crisis of this sort. Because markets were supposed to be efficient, there weren’t supposed to be bubbles. The shocks to the economy were supposed to be exogenous: this one was created by the market itself. Thus, the standard model said the crisis couldn’t or wouldn’t happen; and the standard model had no insights into what generated it." [Stiglitz GT]
But skewering the Friedmanistas was only the beginning of his paper. He goes on to attack the Neo-Keynesians, who he calls "New Keynesians "with rigid wages and prices".
He starts by noting that they share many of the same (non Keynes by the way) assumptions as the Friedmanistas:
"These theories keep most of the assumptions of the Real Business Cycle models, and thus most of their flaws. They represent the minimal change in the conventional competitive equilibrium model required to get sustained unemployment."
He then goes to list some of their faulty assumptions:
- "Nominal rigidities" — they allow that markets may not properly "clear", and thus there can be unemployment.
- "assumed enough flexibility that markets cleared [eventually].
- Price Rigidity: "the problem in deep downturns is not price rigidity but deflation!"
- Efficient markets, Neo Keynesians later admitted "financial friction", but they discarded that.
- "Finance based [neo] New Keynesian model" assumptions:
- Financial frictions — or "Capital market imperfections"
- Macro‐economic externalities are pervasive — meaning that there is an incomplete set of risk markets and imperfections/asymmetries of information and these mean that markets are not "(constrained) Pareto efficient."
- "Balance sheets matter" — whether a company is running a profit or not already determines some of it's behavior.
- "Redistributions matter" — who gets products and resources influences whether money is spent in a way that stimulates more production or is frittered away.
- "one might have thought that not indexing debt contracts has only a distributive impact: the lenders gain (in the face of a negative shock) and the borrowers lose, and these effects too would just cancel. But they do not."
- "Banks as Firms" — he explains how the corporate form influences how banks behave.
- "Why deflation—or disinflation—a problem" — he explains why deflation is an issue.
- He repeats: "the absence of indexing matters" —
- "Balance sheet recessions;" He explains there are "Three Critical aspects of a balance sheet recession:"
In his next section he doesn't so much attack as explain the assumptions and issues within New-Keynesian theories. Much of what he says would be obvious to people who aren't true believers in "efficient markets" and other assumptions of neo-classical economics:
He explains: "Changes in prices that on the face of it might look simply redistributive have real aggregative effects." And he cites the example of debt contracts:
You would think this would be obvious.
"deflation can be a source of problems. The real value of what firms owe and have to pay on their debts increases. This diminishes their net worth from what it otherwise would have been. In effect, deflation increases a firm’s leverage."
"The absence of indexing in itself can lead to lower employment and investment, in the face of bankruptcy costs; and this can help explain the amplification of shocks as well as persistence."...."An adverse shock which lowers net worth induces, as we have noted, less investment and production on the part of each firm—and when such individual decisions are aggregated throughout the economic system, they lead to overall lower output and employment. A small shock to net worth can have a macro‐economic effect which is a multiple of the original shock."
- A shock which leads to an unanticipated worsening of the balance sheets of many firms in the economy.
- The response to the worsening of the balance sheet: a contraction in economic activity; and
- A slow “healing” of balance sheet—necessary and sufficient for the restoration of the economy to full employment.
"standard models [don't] do a good job explaining what happened to non‐bank lending, the vast securitization market that was at the center of the crisis. They simply assumed that markets worked well, that risks had been diversified, and these improvements in risk management were given much of the credit for the “great moderation.” In fact, markets were not working well, and diversification may have made matters worse, rather than better."
He goes on to explain some of the moral hazards enabled by those assumptions and how the Credit Rating Agencies (CRAs) were corrupted by perverse incentives and monopoly into increasing the systemic risk. I note that they did work okay in transferring risks from savvy early investors to later ones and from the banksters to the Public Credit which ended up picking up the losses.
If Diversification cured one of risk, then contagion wouldn't be a risk.
He then notes that the question of persistence is more complex:
"The losses in GDP after the 2008 crisis have been far greater than those associated with the misallocation of resources before crisis, as the economy remained markedly below the crisis level and its pre‐crisis trend growth for a long period. Yet, there are the same real assets (physical, human, natural capital) after the crisis as before. "
Stiglitz looks that the answers provided to explain persistence: "Zero Low Bound" interest rates or simple liquidity traps (lack of aggregate demand". All these seem inadequate as a satisfactory explanation.
Pseudo-Wealth and Victimization
But then Stiglitz finds his:
Asking that question and looking at the speculation that took place, Stiglitz writes:
"Guzman and Stiglitz (2014, 2015a, 2015b) have provided another explanation: before the crisis, differences in views, e.g. about the likelihood of the housing bubble breaking, gave rise to bets (speculation), which led to the creation of pseudo‐wealth—with both sides to the bet believing that they were going to win, both believed that they were wealthy, or more precisely, the aggregate perception of wealth was greater than true wealth. After the crisis, pseudo‐wealth got destroyed. Indeed, there was even negative pseudo‐wealth: borrowers may have believed that what they would pay, in expected value terms, to the lenders was greater than the leaders believed that they would receive." [Stiglitz GT]
He notes that if the real wealth of a society were the same before and after the crisis, and the fault were merely a fault in aggregate demand or liquidity, then fixing it would be relatively easy, and:
"if the market equilibrium depended only on critical aggregate state variables like the state of technology, capital stock, natural resources, and the amount of human capital, then the full employment equilibrium after the crisis would not be much different from that before. Thus, the magnitude of adjustments in wages and prices that would be required to attain full employment would not be that different; and with some degree of wage and price flexibility, full employment should quickly be restored." [Stiglitz GT]
But if the problem was the presence and influence of pseudo wealth then:
"if the economy before the crisis was supported by a bubble or pseudo‐wealth or if there are large distributional effects then there can be large changes in aggregate demand at the previously prevailing wages and prices; and to restore the economy to full employment would require large changes in wages and price."
More important but the collapse of pseudo wealth doesn't spread misery evenly:
"But at least in the short run, these wage and price adjustments in a decentralized market economy can, be destabilizing. Unemployment, an excess supply of labor, leads to lower wages, which reduces aggregate demand. Such changes are redistributive, but the increase in spending out of the increase in profits is less than the decrease in spending by workers; and this is especially so if they worry about their future income and face borrowing constraints. Defaults and expected defaults associated with deflation—because debt contracts are not indexed—worsen banks’ balance sheets, and lead to a contraction in lending."
And he notes:
"Finally, an analysis of deep downturns has to be based on an understanding of why there is such suffering associated with them. If the decrease in hours worked were evenly shared, if there were full intertemporal and interstate smoothing, and if crises were not so persistent, then the social cost of economic fluctuations would be much less."
If we had better policies then the misery would be mitigated; No Greece, no Detroit, no failed states. But we don't have better policies. We have business models that fail because ALL their assumptions are false:
Among the faulty critical assumptions are those in DSGE models [Estimated] dynamic stochastic [general] equilibrium (DSGE) models:
It also increases the probability that families will lose homes, savings, and be more vulnerable to external shocks.
And it is disparities in information and power:
The idea that people can easily convert from Factory workers to Engineers is also bunk:
And as a result:
Finally he starts to draw some conclusions:
They get rich from the "dross" of the burning off of pseudo-wealth, largely by rigging the system. But it may be great personal benefit but it comes at the cost of suffering for the large majority.
He notes in his conclusion:
"Not surprisingly, as we again have noted, the standard models provided inadequate guidance on how to respond. Even after the bubble broke, it was argued that diversification of risk meant that the macroeconomic consequences would be limited. The standard theory also has had little to say about why the downturn has been so prolonged: Years after the onset of the crisis, large parts of the world are operating well below their potential. In some countries and in some dimension, the downturn is as bad or worse than the Great Depression. Moreover, there is a risk of significant hysteresis effects from protracted unemployment, especially of youth." 
"The Real Business Cycle and New [Neo] Keynesian Theories got off to a bad start. They originated out of work undertaken in the 1970s attempting to reconcile the two seemingly distant branches of economics, macro‐economics, centering on explaining the major market failure of unemployment, and microeconomics, the center piece of which was the Fundamental Theorems of Welfare Economics, demonstrating the efficiency of markets."
He then explains how the establishment got to be so wrong. Explaining the "unrealistic assumption(s) of notions like the "representative agent" "that gave [faulty] theoretical structure to the macro‐economic models that were being developed." And concludes:
"(As we noted, New Keynesian DSGE models were but a simple variant of these Real Business Cycles, assuming nominal wage and price rigidities—with explanations, we have suggested, that were hardly persuasive.) There are alternative models to both Real Business Cycles and the New Keynesian DSGE models that provide better insights into the functioning of the macro‐economy, and are more consistent with microbehavior, with new developments of micro‐economics, with what has happened in this and other deep downturns. While these new models differ from the older ones in a multitude of ways, at the center of these models is a wide variety of financial market imperfections and a deep analysis of the process of credit creation. These models provide alternative (and I believe better) insights into what kinds of macroeconomic policies would restore the economy to prosperity and maintain macro‐stability. This lecture has attempted to sketch some elements of these alternative approaches. There is a rich research agenda ahead."
"A corollary of these capital market imperfections is that redistributions have real effects—and this would be true even if all individuals have the same preferences, but is even more so, given that they don’t. Changes in prices that on the face of it might look simply redistributive have real aggregative effects. In a closed economy, for instance, the increase in the price of oil improves the balance sheet of oil producers and hurts those of users, and these two effects might appear to cancel—and they do in the standard perfect markets models. But if there are capital market imperfections, then the changes in, say, demand for investment and employment by those who gain may be far less than the reductions on the part of those who lose." [Stiglitz Paper]
He clearly links these large 'perturbations' (the Great Recession of 2008) to market behavior.
Magnitude of Volatility
He refutes "Rational Expectation theory", linking the magnitude of the volatility in these large perturbations to the failures of the "Rational Expectations" models. Referring to a series of papers by "Greenwald and Stiglitz,.. beginning in the 1980s" and including papers by "Bernanke and Gertler (1990)" that "showed that imperfect information in capital markets" gives "rise to a financial accelerator" that can be positive or negative. As Mandelbrot demonstrated in his work on the relationship between chaos theory and economics, those curves have "fat tales."
Comment on "Pseudo Wealth"
As an economist Stiglitz won't do the kinds of commentary the rest of us can. But when he talks about "Pseudo-Wealth" sirens and lights started going off in my head. He's referring to how the various derivative instruments function like a game of musical chairs rigged by the banks. Everytime the music starts playing and the economic players started dancing, the bankers would start betting on the chairs and telling multiple players that "this will be your chair when the music stops." The result was, when the music stopped there wouldn't be enough "chairs" (niches, properties or money) for everyone who was promised one. "Pseudo-wealth" is another term for "con artists at work."[Stiglitz GT]
One day I'll edit this some more. I mostly created this page to have something to go back to for citations in later writings.