The Stiglitz-Prescott View

by on September 28, 2009 at 7:05 am in Uncategorized | Permalink

Here is Nobel prize-winner Joseph Stiglitz quoted by Free Exchange:

We’ve really extended the safety net beyond to big to fail, and my view is that there’s been no convincing argument that any of this was ever needed. It was based on the notion of fear – that if you didn’t do it, the whole financial set of markets would fail. Economics would have suggested that if you did a debt to equity conversion, converting long-term debt into equity, the financial institution would be well capitalized, there would be no reason to panic, and there would be more confidence in the market. But those who saw an opportunity to use scare tactics to get what they wanted did use those scare tactics, and it worked.

Here is Nobel prize-winner Ed Prescott quoted by Brad DeLong:

[P]eople got scared…. The press scared people. People running for office scared people. Bernanke scared people; Paulson scared people…. [P]eople began not to know what was going to happen. Then they stopped investing–by investing, I mean getting a new car or fixing up your house. And that led to the economy–it was depressed a bit that fourth quarter of last year…[With] benign neglect the economy would have come roaring back quite quickly…

Free Exchange says that Joseph Stiglitz's views are "insane" and Brad DeLong says that Prescott "does not live in the consensus reality with the rest of us."  I am not sure why they are so confident.

1 Harold Jones September 28, 2009 at 7:32 am

I’m certainly willing to believe that statements made by members of the government – executive, legislative and otherwise (the Fed) – and the press had the effect of multiplying the fear. I’m also willing to accept that debt-for-equity conversions ought to have been a part of an ideal response.

My main criticism of the Stiglitz-Prescott view is that their stories are only part of the overall story.

A politician seeking to be seen reflecting the views of her constinuents expresses alarm and concern, but because her constituents experience a sort of repetition bias (not properly discounting the fact that their representative is only echoing their original views), they become _more_ alarmed and concerned as a result. Ditto for the regulator and the (un(der))regulated.

I think proper description would also require appreciating that the crisis was not an event that occured at a single point in time. Remember that, at first, the crisis was widely believed to be one of liquidity and concerns over bank solvency developed over time. It is unfair to judge the Fed, the Treasury and other regulators on their handling of the crisis on the basis of complete knowledge. Criticisms based on what they ought to have recognised beforehand aside, one should only evaluate their performance _during_ the crisis on what was known at each point in time.

2 odograph September 28, 2009 at 8:00 am

When Paulson yelled “fire!” was there a fire? I think so.

I think that in part because it was so out of character for the Bush administration to take over Wall Street.

3 Tomasz Wegrzanowski September 28, 2009 at 8:05 am

You cannot take a recovery as a proof that bailout/stimulus weren’t needed – with our sample size of one, we have no idea how bad it would get without them. Claims like “benign neglect the economy would have come roaring back quite quickly…” pronounced with certainty, and sample size of zero cases are complete nonsense.

On the other hand, pro-bailout/stimulus position only needs risk aversion. If we aren’t sure if market would fix itself or not, fixing it anyway is the safest way to avoid a huge scale disaster.

4 E. Barandiaran September 28, 2009 at 8:25 am

Finally we’re starting to look at what might have been the critical decisions that caused (or at least aggravated severely) the financial crisis.

5 jn September 28, 2009 at 8:31 am

Of course, if even a modest part of the 2008 crisis (say 15-20%) was due to panic or “animal spirits” that argues even more forcefully for the view that insufficiently vigorous monetary policy (esp. the idiotic decision to pay interest on reserves in the Fall) contributed to the creation/extension/expansion of the crisis EVEN if you believe that there was going to be fallout from the subprime crisis and excess leverage for non-monetary reasons.

6 Ryan September 28, 2009 at 8:46 am

The notion that Stiglitz is insane comes from his bizarre and senseless views on other topics. That said, “debt-to-equity conversions” are pretty much black magic. The Wall Street Journal rightly pointed out that it’s basically a process of closing our eyes and pretending that bad assets are good assets. MAGIC! ECONOMY SAVED! That such an idea would be endorsed by Stiglitz is not very surprising.

DeLong is correct that Prescott’s views don’t reflect the broad consensus, but the bigger issue is: who cares? Truth isn’t a popularity contest. Something doesn’t magically become true just because the majority believes it.

7 michael webster September 28, 2009 at 9:02 am

Perhaps the non panic equilibrium is revealed when enough people embrace the Stiglitz/Prescott view?

8 AADL September 28, 2009 at 9:12 am

If DeLong were a stock, he’d be the best short since Enron. His ethics are on the same level too.
The wonder is why MR pays attention to him. Oh, I forgot, feedback loop, longtail, etc.

9 flyerhawk September 28, 2009 at 10:01 am

Danc,

Do you have ANY evidence to support your claim that Obama’s political views had any impact on the economy? Or are you simply creating a theory to meet a result?

It amazes me that people not only believe in a rational market but believe that it is so rational that it is able to make complex political analysis.

10 Andrew September 28, 2009 at 11:01 am

flyerhawk,

The only evidence we have is that all the people who get paid to forecast this stuff are wrong. I’m an investor, albeit a small-time one, and future growth trends are kind of a big deal. Yes, Obama’s policies scared me. Yes, I can do alright by political analysis. Obama has both gotten bogged down and demonstrated that he is not completely insane, so I’m less scared now. I would like a fact-based list of what the Obama administration has actually done, what they’ve said, and what they’ve said they want to do. But unfortunately, the market is informed by “consensus reality.” Would it be a shocker that maybe the Republicans sort of exaggerated Obama’s effect on the economy during the campaign?

11 Steve Verdon September 28, 2009 at 1:07 pm

Isn’t DeLong one of the economists insisting that we’d have a “V” shaped recession vs. a “U” or “L” shaped recession and in particular that we could expect a significant rise in employment? Is that part of his “consensus reality”?

12 Blackadder September 28, 2009 at 1:15 pm

I’m with Andrew. “Consensus reality” is a wonderful concept, and pretty much sums up what’s wrong with a lot of folks’ worldview on such matters.

13 Joe September 28, 2009 at 2:04 pm

Unless I’m missing something (I don’t have Stiglitz’ original comments in context) these are completely different views, Alex.

Stiglitz thinks there was an underlying problem but scared politicians picked the wrong form of intervention (i.e., they should have forced a conversion of debt to equity). So far as I can tell, he doesn’t argue the bailouts failed – he argues there was a more efficient way to fix things.

Prescott thinks that there is no underlying problem – just a drop in demand because the government scared people. (“PRESCOTT: I think the financial crisis has been greatly overstated as a problem… [it] has had virtually no consequences for the real economy.”)

Delong’s insults towards Prescott had little to do with anything Stiglitz mentioned. He was denigrating Prescott specifically for arguing (1) that there was no real underlying crisis, (2) that all we’ve had is a “bit” of a depression in the fourth quarter, and (3) the Fed has stopped attempting to stabilize the economy for 25 years. None of those three things were raised by Stiglitz.

14 Paul September 28, 2009 at 2:13 pm

When scientists start talking about “consensus” views, confident is not the first word that springs to mind.

15 Joe September 28, 2009 at 4:13 pm

Ryan,

Could you explain Mises’ point further? Because it looks like you’re simply assuming the truth of your own argument. (“Markets are rational because you can’t prove they aren’t – even where it looks stupid, I’ll just assume the market had some extremely weird preference!”)

Economists tend to think that markets are not rational because the market sometimes comes to objectively irrational conclusions and often comes to bizarre conclusions that are difficult to square with a rational market.

A publicly traded corporation with limited liability cannot rationally have a negative value – yet the market gave 3Com, other than its ownership interest in Palm, a negative value. Closed-end funds can trade for different prices than the underlying stock portfolio. There are distinct patterns in how markets work that have not been eliminated through arbitrage(the market has a detectable inverse serial correlation [when the market goes up, it is more likely to go down the next day and vice versa], profits from investing are higher when P/E ratios are low, etc.) And that’s leaving aside the problems with the rationality assumption at the consumer level (i.e., Weight Watchers meetings and voluntary Alcanon should not exist in a rational world.)

16 flyerhawk September 28, 2009 at 8:11 pm

Ryan,

How can one argue that the markets are rational if they can never determine the reasoning?

Sociopaths may be rational based on their view of the world but most would agree that their behavior is utterly irrational.

17 Jain McGuinness September 28, 2009 at 10:29 pm

I have a serious question for MR and its commenters. Why is there no mention of competition in the investment banking sector. Is it deemed that sufficient competition exists in finance sector? It seems clear to me that the larest banks were all large enough to be “rent seeking” in Washington. If the issue of “too big to fail” is even raised, it suggests that competition is not enough, Bertrand be damned. The silence on this issue is surprising, given how many of the economic arguments that are used to describe this situation are based on the assumption of competition.

A question for those who have taken small or medium sized companies public in the past 15 years or so: when dealing with your investment bank, did you feel like you were able to shop around and bargain the price of investment services down to the point of “normal profits” or did you feel like you were being robbed on the side of the highway?

18 DanC September 29, 2009 at 1:32 am

flyerhawk

So you claim that what I wrote is not what I wrote. Absurd.

You ask for a specific example. I give you one. You say I am fixated.

You say “the market is indifferent because the market operates on the now and not the future” which shows that you are clueless, perhaps a high school student.

By definition:

In finance, the efficient market hypothesis (EMH) asserts that financial markets are “informationally efficient”, or that prices on traded assets, e.g., stocks, bonds, or property, already reflect all known information and therefore are unbiased in the sense that they reflect the collective beliefs of all investors about future prospects.

The above is the strong version of EMH.

i.e. markets are forward looking

I took Fama’s class. You would fail it.

http://www.dimensional.com/famafrench/2009/08/fama-on-market-efficiency-in-a-volatile-market.html

19 flyerhawk September 29, 2009 at 7:41 am

DanC,

I see you have chosen to delve into ad hominem rather than address my points. Can’t say I’m surprised. No one likes their religion to be challenged.

How exactly does the market “know” the future? The only way that the efficient market theory could possibly be right is if it DIDN’T know the future. How were the markets forward looking in October of 1987? How were they forward looking during the tech boom? And how were they forward looking when it came to derivatives last year?

Regardless I suggest that instead of addressing my points you instead accuse me of being a high school student and engage in pedantic recitals of religious doctrine. That certainly is a far more compelling argument.

20 Ryan September 29, 2009 at 8:50 am

Flyerhawk said: “Sociopaths may be rational based on their view of the world but most would agree that their behavior is utterly irrational.”

Mises himself used sociopaths as an example in his book. The point is that there is a rationale within the mind of a sociopath. It might not make sense to you as the best line of reasoning, and it might take a psychiatrist to decode the rationale and help the sociopath come to better ways of realizing his/her needs through different courses of action.

But, to simply discredit the whole process as “objectively” irrational implies that you, personally, are the one who gets to determine what is rational and what is not. Given that you probably don’t have perfect knowledge on this or any other topic (nor do I), it strikes me as incredibly dismissive and naive to simply pronounce the economy at large “irrational.”

As I said to Joe, there is no need for economics at that point. You can just call everything irrational. No need for further study, theory, or discussion. It is, in essence, expressing a lack of desire to understand what’s happening in the economy.

Furthermore, the fact that this has been an issue since the days of Ludwig von Mises seems to indicate that it’s not going away any time soon. Either you reject the rationality of your fellow humans and forget about economics altogether (in which case I ask you, what do you propose take economics’ place?), or you accept as a fundamental assumption that humans act rationally and it’s the job of an economist to provide theories and explanations for the economy in light of that fact.

I’m not surprised that most recent economists have ignored this debate.

21 Drewfus September 30, 2009 at 1:25 am

The financial institution bailouts were payed for, effectively, by the remainder of the economy. The money had to come from somewhere. The impact of this must have been to increase the general rate of business failure. This would have resulted in more defaults on investment loans. Consequently, this would have meant the bankruptcy of more of the marginal banks, and made more of the remaining banks more marginal.

So the contagion should have occured anyway – there is no such thing as a free lunch. Given that the contagion did not occur, it follows that this theory has no legs.

22 Ryan October 1, 2009 at 1:20 pm

Actually, Joe, it’s you who are confused about what I’m saying. There you are, pronouncing what is and what is not “objectively rational,” assuming that you have enough information to be able to inform the rest of us.

Silly. Every human action is inherently rational for the person engaged in the action. That’s the point. You can rationally disagree with the action or claim that some other course of action is more effective to obtain the ends in question, but to pronounce that someone’s action itself was irrational is a heinous theoretical error.

23 Ryan October 2, 2009 at 9:41 am

Joe,

There is no way you can realistically argue that anyone’s actions are “objectively irrational.” It’s just not possible. Such a claim implies that you have more information about an economic agent’s motives and preferences than they themselves have.

Since this is patently impossible, then you will never be able to truly identify an irrational action.

So you’re right that I am making an assumption of irrationality, but wrong to say that my assumption is incorrect. In fact, this assumption is one of the most fundamental a priori theorems of the field of economics.

Your claims to the contrary can never change this. I apologize if I fall short of “proving you wrong,” but rationality is not a question of proof. It is a fundamental underlying assumption upon which all of economics is based.

As I mentioned above, assuming that people act irrationally explains nothing. It’s tantamount to giving up on the idea that an explanation is possible.

So I can’t prove you wrong, but I also feel no need to do so. If you are assuming that people act irrationally, then you are no longer engaged in the field of economics.

24 Ryan October 2, 2009 at 12:07 pm

Joe,

How silly indeed to assume that once someone is awarded a Nobel Prize their work can never be called into question! But that’s beside the point. As far as I am aware, no part of Behavioral Economics seeks to prove that economic agents act irrationally. If this happens, however, I am confident that their results can easily be overturned notwithstanding any Nobel Prize to the contrary.

Why? Because it is impossible to prove that a theory of irrationality is a more accurate explanation of human behavior than simply taking that economic agent aside and ASKING why he/she did what he/she did. The point is that there exists a rationale behind the behavior. It’s up to you to decide to be aware of it.

This is an epistemological problem.

I challenge you: Define “rationality” and define “irrationality,” and then propose an objective measurement of each. I suspect you will soon find yourself in the same pile of obsolescence as all those who seek to demoninate demand curves with utils. The point is that rationality is not a cardinal measurement, it’s an ordinal one.

As such, you cannot proclaim that anyone’s actions are irrational. You can call them inefficient. You can call them sub-Pareto-Optimal. You can call them the result of assymetrical information. Each of these claims subjects you to certain other criticisms, but at least you’re talking economics at that point.

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