1. INFORMATION AND CAPITAL MARKETS: LESSONS FROM RECENT THEORY AND EXPERIENCES Joseph E. Stiglitz Oscar di Bilancio Lecture December 1, 2004 Milan

2. THE IMPORTANCE OF 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

3. 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 Berkely 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

4. 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

5. 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 lead 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

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

7. 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

8. 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 ANAMOLIES –January effect –Often disappear when brought to light

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. BASIC LESSONS INCENTIVES MATTER –BUT IF THERE ARE THE WRONG INCENTIVES, MARKTS WILL NOT WORK WELL CAPITAL MARKETS ARE NOT INFORMATIONALLY EFFICIENT –BUT PROBLEMS ARE EXACERBATED IF THERE ARE NOT IN PLACE GOOD ACCOUNTING STANDARDS –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

17. CONCLUSIONS 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