Towards a General Theory of Deep Downturns

Presidential Address from the 17th World Congress of the International Economic Association in 2014

Joseph E. Stiglitz

• Publisher: Palgrave Macmillan
• Year: 2016
• ISBN:
  9781137586919
• Topic: Economics
• Subtopic: Political Economy
• Index: Economics

Joseph Stiglitz examines the theory behind the economic downturns that have plagued our world in recent times. This fascinating three-part lecture acknowledges the failure of economic models to successfully predict the 2008 crisis and explores alternative models which, if adopted, could potentially restore a stable and prosperous economy.

1

Three Fundamental Questions

Abstract: This chapter, an extension of the Presidential Address to the International Economic Association, evaluates alternative strands of macroeconomics in terms of the three basic questions posed by deep downturns: What is the source of large perturbations? How can we explain the magnitude of volatility? How do we explain persistence?.

Stiglitz, Joseph E. Towards a General Theory of Deep Downturns: Presidential Address from the 17th World Congress of the International Economic Association in 2014. Basingstoke: Palgrave Macmillan, 2016. DOI: 10.1057/9781137586919.0004.

Economic systems have always exhibited volatility, and economic theorists have long sought to describe and explain these fluctuations. In the United States, the National Bureau of Economic Research began as an attempt to characterize and date business cycles (e.g. with the work of Wesley Mitchell and his student, Simon Kuznets). In the mid-twentieth century, a number of theories explaining why markets endogenously give rise to cyclical fluctuations were developed. Particular attention was paid to inventory cycles. But much of this literature was concerned with small oscillations, not the deep downturns that are the focus of this book.

A.What is the source of large perturbations?

The following are the key questions: Is the source of those major perturbations exogenous or endogenous? And how do economic structures and policies affect the depth and duration of these perturbations?

The standard models (referred to earlier in the “Introduction” and discussed at greater length below) assume that the source of the disturbances to the economy is exogenous. To me, it is clear that that is simply wrong: the credit and housing bubble that was at the center of the 2008 crisis was created by the market. The bubble was a market phenomenon. To assume that it was exogenous is to assume that there is nothing that we can do either to prevent the creation of a bubble or to curtail its size.

Equally troublesome, much of the literature referred to below assumes that the shocks to the economic system are technology shocks. As I explain below, when we look at many of the key economic fluctuations, it is hard to see any changes to technology that could have generated such changes.

Similarly, one of the reasons that the crisis spread so quickly and virulently beyond the borders of the United States was globalization¹ – the result of policies that had been pursued over the previous quarter of a century that resulted, for instance, in much greater financial integration. Again, it is simply wrong to assume that the shocks confronting a country are exogenous: even if the origin of shocks were exogenous, the extent to which a country is exposed to shocks is endogenous. (Indeed, in the case of developing countries, there is a wealth of evidence that most of the shocks to their economies come from outside their borders.)²

B.How can we explain magnitude of volatility?

The change in the physical state variables is typically small, and yet, in deep downturns, the change in output and employment are typically large. Consider the 2008 crisis. There was no destruction of physical or human capital, as often happens in war or in a natural disaster. Yet there were huge changes in the level of macroeconomic activity, corresponding to large changes in the behavior of households and firms.

In many cases, shocks seem to have been amplified, rather than “buffered,” as suggested by traditional economic models, where price adjustments and inventories help absorb shocks and dampen the size of fluctuations.

Earlier literature (the Samuelson accelerator-multiplier model) tried to explain amplification through an investment accelerator: an increase in (expected) growth leads to an increase in the demand for investment goods (to produce the larger output), which then amplifies growth itself. But in the aftermath of the rational expectations revolution, it appeared hard to reconcile such behavior and the cycles to which the accelerator-multiplier model gave rise with rational expectations. For instance, in one variant of these models, at some point the economy reached full employment. This constrained growth. But before that constraint binding, investors should have realized that this would occur; and this would have constrained investment in these earlier periods.

But Greenwald and Stiglitz, in a series of papers beginning in the 1980s,³ and Bernanke and Gertler (1990) showed that imperfect information in capital markets gave rise to a financial accelerator.⁴ In particular, Greenwald and Stiglitz (1993a) explained how shocks to a firm’s equity base (resulting from a shock to the demand it faced, arising from any source) lead to reductions in both demand and supply, its demand for investment goods, its willingness to produce, and its employment. There was an accelerator effect. The effects of shocks were amplified, not dampened. Greenwald and Stiglitz (1991, 2003a) show further amplification effects through similar disturbances to banks’ balance sheets, resulting in potentially large changes in the supply of credit and the terms at which it is made available through the banking system.

C.How do we explain persistence?

The third question is, How do we explain the persistence of the effects of a shock? How do we explain that after the onset of a deep downturn, output and employment remain low? The losses in GDP after the 2008 crisis have been far greater than those associated with the misallocation of resources before the crisis, as the economy remained markedly below the crisis level and its pre-crisis trend growth for a long period.⁵ Yet, there are the same real assets (physical, human, natural capital) after the crisis as before.

More recently, in the aftermath of the 2008 crisis, many have referred to the excess leverage in the economy. But even debt should not matter: standard General Equilibrium theory says that there is a market clearing competitive equilibrium – with full employment. Debt simply is a matter of who has claims on society’s resources. There is nothing in standard equilibrium theory that says that there are patterns of ownership claims that are inconsistent with full employment.

It should be clear that the source of persistence is not in the capital stock or labor supply (though eventually, extended periods of unemployment do have effects on human capital and extended recessions and depressions do have effects on the stock of physical capital). There is persistence in unemployment – and explaining why the economy does not quickly return to full employment is key.

The zero lower bound is not the problem

Recent discussions have focused on the zero lower bound (ZLB) – the inability to lower nominal interest rates below zero. I believe the explanation does not lie (or does not lie just) in the ZLB. The 2008 crisis was, in this respect, markedly different from the Great Depression, when prices were falling at an annual rate of 10%. Then a zero nominal interest rate meant a real interest rate of 10%, enough to discourage investment.⁶ In the recent crisis, prices were increasing at approximately 2%, so the ZLB meant a negative real interest rate of 2%. Some argued that if one could increase inflationary expectations – say by committing to an inflation target of 4% – we could lower the real interest rate, say to minus 4%. Neither theory nor evidence suggests that such a change in the real interest rate would have restored the economy to full employment – even if one could have credibly committed to maintaining inflation at 4%. (Moreover, if the underlying problem was the inability to change intertemporal prices through monetary prices, there was an alternative: changing them through taxes, e.g. through a schedule of changing investment tax credits and consumption tax rates.)

But even if part of the failure of the economy to be restored to full employment did lie in the ZLB, it is critical to understand what gives rise to the ZLB problem. Clearly, the underlying problem is the lack of aggregate demand, the result of liquidity – the ability to spend income – being in the hands of those who do not want to spend (or consume). Before the crisis, the bottom 80% of Americans were spending 110% of their income (on average). This was possible because banks were reckless in their lending; they believed too that the market value of houses represented their true value, so that lending against this collateral was safe. With the breaking of the bubble, the willingness of banks to lend decreased. So too did their ability, with the marked decrease in the value of their net worth. So too did the willingness of households and firms to borrow, as they saw their balance sheets contract. (All of these effects had been earlier analyzed in Greenwald and Stiglitz, 1993a, 2003b.) As we see in the subsequent discussion, if models are constructed in which the economy will always be at full employment in the future and there are no distributional effects, then the possibilities for stimulating the economy today is constrained: more spending today can only be induced by changing intertemporal prices.⁷

Pseudo-wealth

Guzman and Stiglitz (2015a, 2015b, forthcoming) 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 to lenders, in expected value terms, to the lenders was greater than the lenders believed that they would receive.

Dynamics of adjustment

If the real wealth of the economy after the crisis is not much different from that before the crisis, if the market equilibrium depended only on critical aggregate state variables such as the state of technology, capital stock, natural resources, and the amount of human capital,⁸ 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. But if the economy before the crisis was supported by a bubble or pseudo-wealth or if there are large distributional effects,⁹ 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 prices.

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.¹⁰

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...

Table of contents

• Cover
• Title
• Introduction
• 1  Three Fundamental Questions
• 2  Three Strands of Theory
• 3  The Capitalist Economy as a Credit Economy
• Concluding Remarks: The Crisis in Economics
• References