ECONOMICS OF INFORMATION: LESSONS FROM RECENT THEORY AND EXPERIENCES Joseph E. Stiglitz Boise April 2006

The Old Paradigm: Failures of standard paradigm (I) Unemployment—Great Depression Discrimination—economic forces would ensure that economic discrimination could not exist Poverty and inequality-- standard models had little to say about these issues, and argued that efficiency and equity issues could be separated, so one could simply set these issues aside Persistence of seemingly distortionary institutions, like sharecropping Host of more subtle “paradoxes” and puzzles

Host of other failures Micro-economics: tax paradoxes, closed end mutual fund paradox, excess volatility (of stock market and other asset prices), public and corporate financial structure seemed to matter, risk behavior of firms (risk seemed to mean more than just correlation with the business cycle), Macro-economics: cyclical movements of consumption, inventories, real product wages, employment and real consumption wages, determinants of investment Host of unexplained phenomena and institutions (IPOs, payment structures, limited role of new equities in financing new investment)

Ptolemaic attempts to defend the old paradigm Neo-classical synthesis—once government corrects problem of unemployment, standard presumptions hold, include efficiency of markets (Samuelson) Information costs are just like transactions costs, and once these costs are taken into account, the market for information is just like the market for any other good (Stigler, Chicago School) If there were perfect information, sharecropping would not be distortionary

The Competitive Equilibrium Model: Key assumptions Information fixed and essentially perfect Technology fixed—knowledge is fixed Preferences fixed Convexity (diminishing returns) All of these assumptions are questionable Research strategy: explore the most vulnerable assumption—perfect information

From Adam Smith on… Economists’ models had assumed perfect information Knew that it was not good assumption Hoped that a world with “good” information would be close to a world with perfect information Key problem—how to “model” imperfect information, to think about it rigorously –Key breakthrough

The Competitive Equilibrium Model: Implications and central theorems (I) Existence of equilibrium First welfare theorem—every competitive equilibrium is Pareto efficient –Basis of belief in the market economy Every Pareto efficient outcome can be obtained by means of a competitive market, given lump sum redistributions –Can separate out thinking about efficiency and distribution –Economists need only focus on efficiency

Further implications All markets clear Law of single price Law of competitive price—price equals marginal cost Incentives not of much issue—people get paid if and only if they perform contracted for task

Further implications Institutions do not matter—markets see through them The distribution of wealth does not matter Knowing preferences and technology and initial endowments, one can describe the time path of the economy—history does not matter

Political Implications No such thing as unemployment Limited role of government— –Limited market failures—public goods, externalities If there is dissatisfaction with the distribution of income, simply engage in lump sum redistributions –Can separate out completely issues of efficiency and equity

Key problems in constructing new paradigm Modeling “information” and “imperfect information” –Single way in which information is perfect –Infinite number of ways in which information can be imperfect

Modeling Equilibrium –Modeling both sides of market—employer and employee, insurance company and insured, borrower and lender…. –Modeling “rational” behavior, including inferences “in equilibrium” and from “out of equilibrium” moves –Modeling a full set of feasible actions –Dangers from oversimplistic models—with limited number of states (characteristics) there can be full information revelation, while in infinite dimensional real world, there never is

New paradigm Even a small amount of information imperfections can have large effects, destroying all of the central results of economics The invisible hand may be invisible because it is simply not there, or is at best palsied Explains phenomena like unemployment—a micro-foundation for macro-economics Explains other phenomena about which standard theory has little to say Has important policy implications

Central insights of Imperfect information paradigm Information imperfections are pervasive Asymmetries of information are one important form of information imperfections –Sources of asymmetries of information Some “natural” Some created (endogenous) as by-product of other activities –Employer learns about employee as he watches him work –Consequence: “used labor market” very imperfect, explains problems of labor mobility, but recognition of imperfections affects even “new labor” market Some created deliberately, to increase market power –Management attempts to entrench itself by reducing threat of replacement through takeovers (reducing competition in the market for management) or by investments which increase asymmetries of information (Edlin and Stiglitz) –Example of problem of corporate governance

KEY APPLICATION: INFORMATION AND CAPITAL MARKETS CAPITAL MARKETS ARE LIKE THE BRAIN OF THE ECONOMY THEY GATHER, PROCESS, AND DISSEMINATE INFORMATION ON THE BASIS OF WHICH SCARCE CAPITAL IS ALLOCATED HOW WELL THEY PERFORM THEIR TASK HAS MUCH TO DO WITH HOW WELL THE ECONOMY PERFORMS OVERALL

ADAM SMITH’S INVISIBLE HAND MOST IMPORTANT RESULT IN MODERN ECONOMICS –Formal proof not achieved until mid twentieth century by Ken Arrow of Stanford and Gerard Debreu of Berkeley HOLDS THAT COMPETITIVE MARKETS ALLOCATE RESOURCES EFFICIENTLY –Though does not in general result in social justice or even an acceptable distribution of income THE PRICE SYSTEM AND THE PURSUIT OF SELF INTEREST LEADS, AS IF BY AN INVISIBLE HAND, TO ECONOMIC EFFICIENCY

AN IMPORTANT WARNING GREENWALD AND STIGLITZ SHOWED IN MID 80S THAT WHEN INFORMATION AND MARKETS ARE IMPERFECT—THAT IS ALWAYS--ADAM SMITH’S INVISIBLE HAND THEOREM IS NOT TRUE THE REASON THAT THE INVISIBLE HAND OFTEN SEEMS INVISIBLE IS THAT IT’S NOT THERE ESPECIALLY IMPORTANT IN THINKING ABOUT CAPITAL MARKETS—WHICH CENTER AROUND INFORMATION

Hint of future argument: greed (extreme form of pursuit of self interest) so evident in U.S. during Roaring 90s, did not lead to economic efficiency. – It led to Bubble that burst. –During Bubble massive misallocation of resources –After burst, massive underutilization of resources—over last four years gap between economy’s potential and actual output (cumulatively) around $1.7 trillion Problems were pervasive –Not just a question of a few rotten apples –Have to look for systemic origins –No reason to believe that generation of the 90s more immoral than earlier generations –Have to look for changes in incentives Every person has his price In 90’s, more people found that price

“Chicago Perfect Markets School”: CAPITAL MARKETS ARE EFFICIENT PERFECTLY TRANSMITTING ALL INFORMATION IMPORTANT IMPLICATIONS –Buy indexed funds –Can’t beat the market

FIRST CHALLENGE: Imperfect Information School GROSSMAN STIGLITZ –IMPOSSIBILITY OF INFORMATIONALLY EFFICIENT MARKETS IF MARKETS WERE INFORMATIONALLY EFFICIENT, NO ONE WOULD HAVE ANY INCENTIVE TO GATHER INFORMATION ONLY INFORMATION IN THE MARKET WOULD BE ‘FREE’ INFORMATION MARKETS ARE CHARACTERIZED BY AN EQUILIBRIUM LEVEL OF DISEQUILIBRIUM

CHALLENGE II Irrationality MARKETS CHARACTERIZED BY IRRATIONAL EXUBERANCE AND PESSIMISM REFLECTED IN EXCESS VOLATILITY –Could any “news” justify wiping out 25% of capital value of stock market in 1997, or even larger fraction of tech stocks in 2000? LARGE NUMBER OF STOCK MARKET ANOMALIES –January effect –Often disappear when brought to light

EXPLANATIONS I Behavioral Economics Kanehman (Nobel Prize 2002) and Tvsersky recognized that there were systematic ways in which individuals behaved that were hard to reconcile with rationality Anchoring Difficulties in making probabilistic judgments, especially about rare events Excessive myopia Herd behavior Long recognized in standard Keynesian macro- economics –“animal spirits” –Money illusion

EXPLANATION II Information Economics FOR PRICE SYSTEM TO WORK WELL, PRICES MUST BE BASED ON GOOD (UNDISTORTED INFORMATION) IN 90’S INCENTIVES WERE IN PLACE TO PRODUCE DISTORTED INFORMATION

STOCK OPTIONS SOLD AS METHOD OF PROVIDING STRONG INCENTIVES IN FACT, THERE WERE BETTER WAYS OF PROVIDING OF INCENTIVES (RELATIVE PERFORMANCE) –LESS DEPENDENT ON VAGARIES OF STOCK MARKET –PROVIDING STRONGER INCENTIVES WITH LESS RISK IN FACT, ACTUALLY PROVIDED WEAK INCENTIVES –PAY REMAINED HIGH IN 2000, 2001 EVEN WHEN STOCK PRICE WENT DOWN

STOCK OPTIONS ACCOUNTING FRAMEWORKS MADE IT DIFFICULT TO ASCERTAIN EXTENT TO WHICH SHARE VALUE WAS DILUTED—COST TO SHAREHOLDER EXECUTIVES HAD INCENTIVE TO PROVIDE INFORMATION WHICH LED TO INCREASE IN STOCK PRICE (IN SHORT RUN) PROBLEM RECOGNIZED IN EARLY 90S, BUT TO MANY WERE BENEFITING TO MAKE CHANGE CONFLICT OF INTEREST—BETWEEN SERVING INTERESTS OF SHAREHOLDERS AND THEIR OWN INTERESTS

ACCOUNTANTS WERE SUPPOSED TO PROVIDE CHECK ON CORPORATIONS BUT, HIRED BY CEO’S, AND WITH MOST OF INCOME DERIVED FROM CONSULTING, THEIR INCENTIVE WAS TO PLEASE CEO. ANOTHER CONFLICT OF INTEREST RECOGNIZED IN MID 90S BUT THOSE WHO BENEFITED RESISTED CHANGE

BANKS ANALYSTS –PAID BY INVESTMENT BANKS –BUT SUPPOSED TO PROVIDE ACCURATE INFORMATION –OBVIOUS POTENTIAL CONFLICT OF INTEREST –PLAYED OUT IN 90s IPO discounts made it worse GLASS-STEAGALL –SEPARATION OF COMMERCIAL AND INVESTMENT BANKS –TO AVOID CONFLICTS OF INTEREST –CREATED CHINESE WALLS –BUT WHAT WAS ADVANTAGE OF MERGER WITH CHINESE WALLS –IN FACT, CHINESE WALLS WERE NOT VERY HIGH –FEARS OF CONFLICT REALIZED

SELF REGULATION NEW YORK STOCK EXCHANGE OBVIOUS POTENTIAL FOR CONFLICT OF INTEREST WITH SALARY OF SELF- REGULATOR SET BY THOSE HE REGULATES EXPOSED BY GRASSO ABUSES

BASIC LESSONS INCENTIVES MATTER –BUT IF THERE ARE THE WRONG INCENTIVES, MARKETS WILL NOT WORK WELL CAPITAL MARKETS ARE NOT INFORMATIONALLY EFFICIENT –BUT PROBLEMS ARE EXACERBATED IF GOOD ACCOUNTING STANDARDS ARE NOT IN PLACE –IF THERE ARE CONFLICTS OF INTEREST, LEADING TO BAD INFORMATION AND THE FAILURE OF SYSTEM OF CHECKS AND BALANCES –ACCOUNTANTS AND BANKS ARE SUPPOSED TO PROVIDE SOME OF THE NECESSARY CHECKS AND BALANCES –BUT THEY TOO HAD THE WRONG INCENTIVES –A FAILURE OF CORPORATE GOVERNANCE WITH COSTS TO SHAREHOLDERS AND TO OTHER STAKEHOLDERS

THE ROARING 90S CONCLUSIONS: LESSONS OF THE ROARING 90S MARKETS ARE AT THE CENTER OF A SUCCESSFUL ECONOMY BUT SUCCESS ALSO REQUIRES GETTING RIGHT THE BALANCE BETWEEN GOVERNMENT AND MARKETS –INCLUDING REGULATORY FRAMEWORKS TO AVOID CONFLICTS OF INTEREST ADAM SMITH WAS WRONG –BUT WITH APPROPRIATE ROLE FOR GOVERNMENT, MARKETS ARE MORE LIKELY TO LEAD TO ECONOMIC EFFICIENCY

The Political Economy of Information BEYOND ECONOMICS: The Political Economy of Information Asymmetries of information pervade political processes as they do economic processes With equally important incentives to crease asymmetries of information (secrecy) –To hide failures, corruption Secrecy results in an artificially created scarcity of information –Like other artificially created scarcities, gives rise to rents –Rents can be exchanged for “favors”, especially from Press –Resulting in distorted information flows Importance of right-to-know (freedom of information acts) to reduce scope for creation of asymmetries of information

LESSONS FOR ECONOMIC THEORY AND POLICY Standard Paradigm had large number of failings –Still explained many phenomena—explains survival New information paradigm undermined key propositions –Provided explanations for phenomena about which neoclassical theory had little to say –Provided explanations for phenomena that were seemingly inconsistent with standard paradigm Most importantly, unemployment Markedly different view of the role of government –Which seems government and markets as partners, as complements Economic policies based on economic theory—not on simplistic ideology—are more likely to lead to stronger economic performance