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RETHINKINGMACROECONOMICS:WHATWENTWRONGANDHOWTOFIXIT
JosephE.Stiglitz
AdamSmithLecture
EuropeanEconomicAssociationGlasgow
August24,2010
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Outline
Thefailuresoftheexistingparadigm
Andthepolicyframeworksbasedonthem
Explainingthefailures: keyassumptions,key
omissionsSomemethodologicalremarks
Keyunansweredquestions
Fivehypotheses
Newframeworks/models
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GeneralConsensus:
StandardeconomicmodelsdidnotpredictthecrisisAndpredictionisthetestofanyscience
Worse: Mostofthestandardmodels(includingthoseusedbypolicymakers)arguedthatbubbles
couldnt exist,becausemarketsareefficientandstableManyofthestandardmodelsassumedtherecouldbe
nounemployment(labormarketsclear)
Iftherewasunemployment,itwasbecauseofwagerigidities Implyingcountrieswithmoreflexiblelabormarketswould
havelowerunemployment
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SixFlawsinPolicyFramework
Policymakingframeworksbasedonthatmodel(or
conventionalwisdom)wereequallyflawed Maintainingpricestabilityisnecessaryand
almostsufficientforgrowthandstabilityItisnottheroleoftheFedtoensurestabilityofasset
prices
Markets,bythemselves,areefficient,self
correctingCanthereforerelyonselfregulation
Inparticular,therecannotbebubblesJustalittlefrothinthehousingmarket
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ConventionalPolicyWisdom
Eveniftheremightbeabubble,couldntbesure,untilafteritbreaks
Andinanycase,theinterestrateisabluntinstrument
Usingittobreakbubblewilldistorteconomyandhaveotheradversesideeffects
Lessexpensivetocleanupaproblemafterbubblebreaks
IMPLICATION:
DO
NOTHINGExpectedbenefitsmall,expectedcostlarge
EACHOFTHESEPROPOSITIONSISFLAWED
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1.Inflationtargeting
Distortionsfromrelativecommoditypricesbeingoutofequilibriumasaresultofinflationaresecondorder
relativetolossesfromfinancialsectordistortions Bothbeforethecrisis,evenmore,afterthebubblebroke
Ensuringlowinflationdoesnotsufficetoensurehighand
stablegrowth Moregenerally,nogeneraltheoremthatoptimal
responsetoaperturbationleadingtomoreinflationistoraiseinterestrate
Dependsonsourceofdisturbance
Inflationtargetingrisksshiftingattentionawayfromfirstorderconcerns
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2. Marketsareneitherefficientnor
selfcorrecting Generaltheorem: wheneverinformationisimperfector
riskmarketsincomplete(thatis,always)marketsarenotconstrained
Pareto
efficient
(Greenwald
Stiglitz) Pervasiveexternalities
Pervasiveagency
problems
Manifestinfinancialsector(e.g.intheirincentivestructure)
Greenspan
should
not
have
been
surprised
at
risksthey
had
incentivetoundertakeexcessiverisk Bothattheindividuallevel(agencyproblems) Andorganizational(toobigtofail) Problemsoftoobigtofailbankshadgrownmarkedlyworsein
previousdecadeasaresultofrepealofGlassSteagall Systemicconsequences(whichmarketparticipantswillnot
takeintoaccount)arethereasonwehaveregulation Especiallysignificantwhengovernmentprovides(implicitor
explicit)insurance
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3. Therecannotbebubbles..
Bubbleshavemarkedcapitalismsincethe
beginning Bubblesareevenconsistentwithmodelsof
rationalexpectations
(Allen,
Morris,
and
Postlewaite 1993)andrationalarbitrage(Abreu
andBrunnermeier
2003).
Collateralbasedcreditsystemsareespecially
pronetobubbles
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4. Cantbesure
Allpolicyismadeinthecontextofuncertainty
Ashousingpricescontinuedtoincrease eventhoughrealincomesofmostAmericanswere
decliningit
was
increasingly
likely
that
therewasabubble
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5. Wehadnoinstruments
Wehadinstruments Congresshadgiventhemadditionalauthorityin1994
Ifneededmoreauthority,could/shouldhavegonetoCongresstoaskforit Couldhaveusedregulations(loantovalueratios)todampen
bubble Hadbeenbrieflymentionedduringtechbubble
Ideologicalcommitmentnottointerveneinthemarket Butsettinginterestratesisaninterventioninthemarket
Generalconsensusontheneedforsuchintervention Ramseytheorem: singleinterventioningeneralnotoptimal Tinbergen: withmultipleobjectivesneedmultipleinstruments
Evenwithsingleobjective,withriskpreferabletousemultiple
instruments Theyhadmultipleinstruments
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6. Lessexpensivetocleanupthe
mess Fewwouldagreewiththattoday
Lossbeforethebubblebrokeinhundredsofbillions
Lossafterthebubbleintrillions
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Whatwentwrong? Whydidthe
modelsfail? Allmodelsrepresentsimplification
Keyissue: whatwerethecriticalomissionsofthestandardmodels? Whatwerethemostmisleadingassumptionsofthemodels? Answerdependspartlyonthequestionsbeingasked
Widevarietyofmodelsemployed,soanybriefdiscussionhastoentailsomecaricature
Dynamic,stochastic,generalequilibriummodels
focusedon
three
key
elements
Macrodynamicscrucial
Uncertaintyiscentral
Andpartialequilibriummodelsarelikelytobemisleading
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KeyProblem
Notwithdynamicstochasticgeneralequilibrium analysisbutspecificassumptionsNeedtosimplifysomewhereProblemisthatStandardModelsmadewrong
simplifications Inrepresentativeagentmodels,thereisnoscopeforinformation
asymmetries(exceptwithacuteschizophrenia)
Inrepresentativeagentmodels,thereisnoscopeforredistributiveeffects
Inrepresentativeagentmodels,thereisnoscopeforafinancial
sector Whoislendingtowhom?Andwhatdoesbankruptcymean?
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Argumentsforsimplifications
uncompelling Needtoreconcilemacro withmicroeconomics,deriveaggregaterelationsfrommicrofoundations
Butstandardmicrotheoryputsfewrestrictionsonaggregatedemandfunctions(Mantel,Sonnenschein)
Restrictionsresultfromassumingrepresentativeagent
Hardtoreconcilemacrobehaviorwithreasonablespecifications(e.g.laborsupply,riskaversion)
Importanttoderivemacrobehaviorfromright
micro
foundations Consistentwithactualbehavior
Takingintoaccountinformationasymmetries,imperfections
Goingforward: exploreimplicationsofdifferentsimplifications
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RecentProgress
RecentDSGEmodelshavegonebeyond
representativeagentmodelsand
incorporatedcapitalmarketimperfections
Questionremains: Havetheyincorporatedkey
sourcesofheterogeneityandcapitalmarketimperfections
Lifecyclecentraltobehaviormodelswithinfinitely
livedindividualshavenolifecycle
Factordistributionkeytoincome/wealthdistribution
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Equityandcreditconstraintsbothplayakeyrole
Asdodifferencesbetweenbankandshadowbanking
system
Somenotablesuccesses(Korinek,JeaneKorinek)
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AskingtheRightQuestions
Testofagoodmacromodelisnotwhetherit
predictsa
little
better
in
normal times,butwhetheritanticipatesabnormaltimesand
describeswhathappensthen
Blackholesnormally dontoccurStandardeconomicmethodologywouldthereforediscardphysicsmodelsinwhichtheyplayacentral
roleRecessionisapathologythroughwhichwecancome
tounderstandbetterthefunctioningofanormaleconomy
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Majorpuzzle: Fastdeclines,slow
recoveries1.
Intheabsenceofwar,statevariables(capitalstocks)changeslowly. Whythencanthestateoftheeconomychangeso
quickly? Importanceofexpectations
Butthatjustpushesthequestionbackfurther: whyshouldexpectationschangesodramatically,withoutanybignews?
EspeciallywithrationalindividualsformingBayesianexpectations
PuzzleofOctober,1987HowcouldaquarterofthePDVofthecapitalstockdisappearovernight?
Discretegovernmentpolicychanges Removingimplicitgovernmentguarantee(adiscreteaction)
Dramaticincreasesininterestrates(EastAsia)
Butthesediscretepolicychangesusuallyarearesultofsudden
changes
instateofeconomy Thoughintendedtodampentheeffects,theysometimeshaveoppositeeffectof
amplification
L C St t E
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LargeC anges nStateo EconomyfromSmallChangesinState
Variables Consequenceofimportantnonlinearities ineconomicstructure
Familiarfromoldnonlinearbusinesscyclemodels
(Goodwin)
Individualsfacingcreditconstraints
LeadingtoendofbubbleThoughwithindividualheterogeneity,eventhen
therecan/shouldbesomesmoothing
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FastDeclines
Whatevercause,changesinexpectationscangiverise
tolargechangesin(asset)prices
Andwhatevercause,effectsoflargechangesinprices
canbeamplified
byeconomicstructure(withfollow
oneffects
that
are
prolonged)
Understandingamplificationshouldbeoneofkey
objectivesofresearch
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Amplification
Financialaccelerator(derivedfromcapitalmarketimperfectionsrelatedtoinformationasymmetries)
(GreenwaldStiglitz,1993,BernankeGertler,1995)
Trendreinforcement
effectsinstochasticmodels
(Battiston
etal2010)
Newuncertainties: Largechangesinpricesleadtolargeincreasesin
uncertaintiesaboutnetworthofdifferentmarket
participants
abilitytofulfillcontracts
Changesinriskperceptions(notjustmeans)matter
Crisisshowedthatprevailingbeliefsmightnotbecorrect
Anddramaticallyincreaseduncertainties
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AmplificationsImplyFastDeclines
NewInformationimperfections Anylargechangeinpricescangiverisetoinformation
asymmetries/imperfectionswithrealconsequences Indeed,evenasmallchangeinpricescanhavefirstordereffectsonwelfare(andbehavior) Unlikestandardmodel,wheremarketequilibriumisPO(envelopetheorem
Redistributions Withlargepricechanges,largegamblestherecanbefast
redistributions(balancesheeteffects)withlargerealconsequences
Especiallyiftherearelargedifferencesamongindividuals/firms
Withsomefacingconstraints,othersnot
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Control
Whoexercisescontrolmatters(unlikestandardneoclassical
model) Canbediscretechangesinbehavior
Withbankruptcyandredistributions,therecanbequick
changesin
control
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2. SlowRecovery
Therewerelargelossesassociatedwithmisallocationofcapitalbeforethebubblebroke. Itiseasytoconstruct
modelsofbubbles. Butmostofthelossesoccurafterthebubblebreaks,inthepersistentgapbetweenactualandpotentialoutput Standardtheorypredictsarelativelyquickrecovery,asthe
economyadjuststonewrealityNewequilibriumassociatedwithnewstatevariables(treating
expectationsasastatevariable)
Andsometimesthatisthecase(Vshapedrecovery)
ButsometimestherecoveryisveryslowPersistenceofeffectsofshocks
(partiallyexplainedbyinformation/creditmarketimperfections(GreenwaldStiglitz))rebuildingbalancesheetstakestime
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FightoverWhoBearsLosses
Afterbubblebreaks,claimsonassetsexceedvalueofassets
Someonehastobearlosses;fightisoverwhobearslosses
Fightoverwhobearslossesandresultingambiguityinlongtermownershipcontributestoslowrecovery
Standardresultintheoryofbargainingwithasymmetricinformation
Threewaysofresolving Inflation
Bankruptcy/assetrestructuring
Muddlingthrough(nontransparentaccountingavoidingbankrecapitalization,slowforeclosure)
Americahaschosenthirdcourse
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NewFrameworks
Frameworksfocusingon
1. Risk2.
Informationimperfections
3. Structuraltransformation4. Stability
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andFourHypotheses
HypothesisA: Therehavebeenlarge(andoftenadverse)changesintheeconomysriskproperties,inspiteofsupposedimprovementsinmarkets
HypothesisB: Movingfrombanks
tomarketspredictablyledtodeteriorationinqualityofinformation
HypothesisC: structuraltransformationsmaybeassociatedwithextendedperiodsofunderutilizationofresources
HypothesisD: Especiallywithinformationimperfections,marketadjustmentstoaperturbationfromequilibriummaybe(locally) destablizing
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UnderlyingTheorem
Marketsarenotingeneral(constrained)
ParetoefficientOnceasymmetriesininformation/imperfections
ofriskmarketsaretakenintoaccount
Noraretheystable
Inresponsetosmallperturbations
Andevenlesssoinresponsetolargedisturbances
associatedwithstructuraltransformation
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Insufficient attention to architecture
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Insufficientattentionto architecture
ofrisk
Theorywasthatdiversificationwouldleadtolowerrisk,morestableeconomy
Didnthappen:
where
did
theory
go
wrong?
Mathematics: Madeassumptionsinwhichspreadingrisknecessarilyincreases
expectedutility Withnonconvexities(e.g.associatedwithbankruptcy,R&D)itcan
leadtolowereconomicperformance Twosidesreflectedinstandarddebate
Beforecrisisadvantagesofglobalization Aftercrisesrisksofcontagion Bank bailoutseparateoutgoodloansfrombad(unmixing)
Standardmodelsonlyreflectformer,notlatter Shouldreflectboth Optimalelectricgrids Circuitbreakers
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NewResearch
Recentresearchreflectingboth
FullintegrationmayneverbedesirableStiglitz,AER 2010,JournalofGlobalizationandDevelopment,2010:Inlifecyclemodel,capitalmarketliberalizationincreasesconsumptionvolatilityandmaylowerexpectedutility
Stiglitz,OxfordReviewofEconomicPolicyOxfordReviewofEconomicPolicy,2004
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NewResearch
Showinghoweconomicstructures,including
interlinkages,interdependencies
can
affect
systemicrisk
Privatelyprofitableinterlinkages
(contracts)are
not,ingeneral,constrainedParetoefficient AnothercorollaryofGreenwaldStiglitz
1986
Interconnectivitycanhelpabsorbsmallshocksbut
exacerbatelargeshocks,canbebeneficialingoodtimesbutdetrimentalinbadtimes
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Furtherresults: DesignMatters Poorlydesignedstructurescanincreasesrisk
ofbankruptcycascades
Greenwald&Stiglitz (2003),AllenGale(2000) Hubsystemsmaybemorevulnerabletosystemicriskassociatedwithcertaintypesofshocks
Many
financial
systems
have
concentrated
nodes Circuitbreakerscanaffectsystemicstability
Realproblemincontagionisnotthose
countriessufferingfromcrisis(dealingwiththatisakintosymptomaticrelief)butthehubsintheadvancedindustrialcountry
Haldane (2009),Haldane &May(2010),Battiston etal(2007,2009),Gallegati etal(2006,2009),
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Canbeaffectedbypolicyframeworks
Bankruptcy
law(indenturedservitude)
Lendersmaytakelesscareingivingloans
(Miller/Stiglitz,1999,2010) Morecompetitivebankingsystemlowersfranchisevalue
Mayleadtoexcessiverisktaking (Hellman,Murdock,andStiglitz,2000)
Excessiverelianceoncapitaladequacystandardscanleadtoincreasedamplification(unlesscyclicallyadjusted) Capitalmarketliberalization
Flowsintoandoutofcountrycanincreaseriskofinstability
Financialmarketliberalization Mayhaveplayedaroleinspreadingcrisis InmanyLDCs,liberalizationhasbeenassociatedwithless
lendingtoSMEs
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HypothesisB: Movingfrombanks
tomarketspredictablyledtodeteriorationinqualityofinformation
InherentinformationprobleminmarketsThepublicgoodisapublicgood
Goodinformation/managementisapublicgood
Shadowbankingsystemnotasubstituteforbankingsystem
Leadingto
deterioration
in
quality
of
lending
Inherentproblemsinratingagencies Butalsoincreasedproblemsassociatedwithrenegotiationof
contracts(Increasinglitigationrisk)
Improvingmarkets
mayleadtolowerinformationcontentin
markets ExtensionofGrossmanStiglitz
Problemsposedbyflashtrading? (Inzerosumgame,moreinformationrentsappropriatedbythoselookingatbehaviorofthosewhogatherandprocessinformation)
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Again: Marketequilibriumisnotin
generalefficientDerivativesmarketanexampleLargefractionofmarketoverthecounter,nontransparent
Hugeexposuresin
billionsPreviousdiscussionemphasizedrisksposedbyinterconnectivity
Furtherproblemsposedbylackoftransparencyofoverthecountermarket
Underminingabilitytohavemarketdiscipline Marketcouldntassessriskstowhichfirmwasexposed Impededbasicnotionsofdecentralizibility
Neededtoknowriskpositionofcounterparties,inaninfiniteweb
Explaininglackoftransparency: Ensuringthatthosewhogatheredinformationgotinformation
rents? Exploitationofmarketignorance? Corruption(asinIPOscandalsinUSearlierindecade)?
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3. StructuralTransformation
GreatDepressionwasaperiodofstructuraltransformationmovefromagriculturaltoindustry;GreatRecessionisanotherperiodofstructuraltransformation(frommanufacturingto
servicesector,
induced
by
productivity
increases
andchangesincomparativeadvantagebroughtonbyglobalization)
Rationalexpectationsmodelsprovidelittleinsightsinthesesituations
Periodsofhighuncertainty,information
imperfections
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HypothesisC: structuraltransformationsmaybeassociatedwithextendedperiodsofunderutilizationofresources
Withelasticityofdemandlessthanunity,sectorwithhighproductivityhasdecliningincome
Theremaybehighcapitalcosts(includingindividual
specificnoncollateralizable investments)associatedwithtransitionbutwithdecliningincomes,itmaybeimpossibletofinancetransitionprivately
Capital
market
imperfections
related
to
information
asymmetries Decliningincomesintrapped
highproductivitysectorhas
adverseeffectonothersectors
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4. Instability
HypothesisD: Especiallywithinformationimperfections,marketadjustmentstoaperturbationfromequilibriummaybe(locally) destablizing
Questionnotaskedbystandardtheorem Partialequilibriummodelssuggeststability ButFisher/Greenwald/Stiglitz
pricedebtdynamicssuggest
otherwise Withunemployment,wageandpricedeclinesoreven
increasesthatarelessthanexpectedcanloweremploymentandaggregatedemand,andcanhaveassetpriceeffectswhichfurther
Loweraggregatedemandandincreaseunemploymentand Loweraggregatesupplyandincreaseunemploymentstill
further
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Thiscrisis
Combineselementsofincreasedrisk,reducedqualityofinformation,astructuraltransformation,withtwomoreingredients:
Growinginequalitydomestically,whichwould
normallyleadtolowersavingsrateExceptinarepresentativeagentmodel
Obfuscatedbygrowingindebtedness,bubble
GrowingglobalreservesRapidlygrowingglobalprecautionarysavings
Effectsobfuscatedbyrealestatebubble
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TowardsaNewMacroeconomics
Shouldbeclearthatstandardmodelswereill equippedtoaddresskeyissuesdiscussedaboveAssumptionsruledoutorignoredmanykeyissues
Manyofrisksrepresentredistributions
Howtheseredistributionsaffectaggregatebehavioriscentral
NewMacroeconomicsneedstoincorporateananalysisofRisk,Information,Institutions,Stability,setinacontextof
Inequality
Globalization
StructuralTransformation
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Withgreatersensitivitytoassumptions(includingmathematicalassumptions)thateffectivelyassumewhatwastobeproved(e.g.withrespecttobenefitsofriskdiversification,effectsof
redistributions)
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AnExample: MonetaryEconomics
withBanks Repositoryofinstitutionalknowledge
(information)thatisnoteasilytransferredInternalizationofinformationexternalities
providesbetterincentivesintheacquisitionof
information
Cost: lackofdirect diversificationofriskThough
shareholder
risk
diversification
can
still
occur
Butriskdiversificationattenuatesinformation
incentives
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BanksstilllocusofmostSMElending
VariabilityinSMEcentraltounderstandingmacroeconomicvariability(employment,
investment)
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Standardmodelsdidntmodelbankingsectorcarefully(oratall)OftensummarizedinamoneydemandequationMayworkOKinnormaltimes
Butnotnow,orinothertimesofcrisis(EastAsia)
Keychannelthroughmonetarypolicyaffectstheeconomyisavailabilityofcredit(GreenwaldStiglitz,2003,TowardsaNewParadigminMonetaryEconomics)Andthetermsatwhichitisavailable(spreadbetweenT
billrateandlendingrate)isanendogenous variable,
whichcanbeaffectedbyconventionalpoliciesandregulatorypolicies)
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Anexample
Assumenochangeincontrol,bankmanagers
maximizeexpected
utility
of
profits
to
old
owners
(dontcareaboutreturnstogovernment)
MaxU()
where =max{(1 )(Y rB rg Bg
),0}
where
representsthedilutiontogovernment
(throughsharesand/orwarrants)andrg
isthe
coupononthepreferredsharesandBg
isthe
capitalinjectionthoughpreferredshares)
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Threestatesofnature(assumingcanorderby
levelofmacroeconomicactivity)(a) 1
: bankgoesbankrupt
(b)
1
2: oldownersmakenoprofit,but
bankdoesnotgobankrupt
(c)
2: bankmakesprofitforoldowners,
preferredsharesarefullypaidFinancingthroughpreferredshares
with/withoutwarrantsvs.equityaffectssize
ofeachregionandweightputoneach
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Ifgovernmentchargesactuariallyfairinterestrate
onpreferredshares,thenrg
>r,so(i)regioninwhich
oldownersmakenoprofitisactuallyincreased;(ii)
largerfractionofgovernmentcompensationinform
ofwarrants,largerregion(a)andlessweightplacedon(a)versus(b)[lessdistorteddecisionmaking]
Optimal: fullshareownership
Worst(withrespecttodecisionmaking): injecting
capitaljustthroughpreferredshares
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ConcludingRemarks
Modelsandpolicyframeworks(includingmanyusedbyCentralBanks)contributedtotheirfailuresbeforeandafter
thecrisis
Andalsoprovidelessguidanceonhowtoachievegrowthwithstability(accesstofinance)
Fortunately,newmodelsprovidealternativeframeworks
Manyofcentralingredientsalreadyavailable Creditavailability/bankingbehavior
Creditinterlinkages
Morebroadly,sensitiveto(i)agencyproblems;(ii)externalities;and
(iii)
broader
set
of
market
failures Modelsbasedonrationalbehaviorandrationalexpectations(even
withinformationasymmetries)cannotfullyexplainwhatisobserved
Buttherecanbesystematicpatternsinirrationality,thatcanbestudiedandincorporatedintoourmodels
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ConcludingRemarks
Lesslikelythatasinglemodel,asimple(butwrong)paradigmwilldominateasitdidinthepast
TradeoffsinmodelingGreaterrealisminmodelingbanking/shadowbanking,key
distributionalissues(lifecycle),keyfinancialmarket
constraints maynecessitatesimplifyinginother,lessimportantdirections
Complexitiesarisingfromintertemporal
maximization
overaninfinitehorizonoffarlessimportancethan
thoseassociatedwithanaccuratedepictionoffinancialmarkets
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NewPolicyFrameworks
Newpolicyframeworksneedtobedevelopedbasedonthisnewmacroeconomicmodeling
Focusnotjustonpricestabilitybutalsoinfinancialstability