Information and the change in the paradigm in economics, Part 2

American Economist, Spring, 2004 by Joseph E. Stiglitz

APPLICATIONS OF THE NEW PARADIGM

The new theory of the firm and the foundations of modern macro-economics

Of all the market failures, the extended periods of underutilization of resources--especially human resources--is of the greatest moment, the consequences of which in turn are exacerbated by capital market imperfections, which means that even if future prospects of an unemployed individual are good, he cannot borrow to sustain his standard of living.

We referred earlier to the dissatisfaction with traditional Keynesian explanations, in particular, the lack of micro-foundations. This gave rise to two schools of thought. One sought to use the old perfect market paradigm, relying heavily on representative agent models. While information was not perfect, expectations were rational. But the representative agent model, by construction, ruled out the information asymmetries which are at the heart of macro-economic problems. Only if an individual has a severe case of schizophrenia is it possible for such problems to arise. If one begins with a model that assumes that markets clear, it is hard to see how one can get much insight into unemployment (the failure of the labor market to clear).

The construction of a macro-economic model which embraces the consequences of imperfections of information in labor, product, and capital markets has become one of my major preoccupations over the past fifteen years. Given the complexity of each of these markets, creating a general equilibrium model--simple enough to be taught to graduate students or used by policy makers--has not proven to be an easy task. At the heart of that model lies a new theory of the firm, for which the theory of asymmetric information provides the foundations. The modern theory of the firm in turn rests on three pillars, the theory of corporate finance, the theory of corporate governance, and the theory of organizational design.

The theory of corporate finance

Under the older, perfect information theory, it made no difference whether firms raised capital by debt or equity, in the absence of tax distortions. (102) This was the central insight of the Modigliani-Miller theorem. (103) We have noted how the willingness to hold (or to sell) shares conveys information, so that how firms raise capital does make a difference. (104) Firms rely heavily on debt finance, and bankruptcy, resulting from the failure to meet debt obligations, matters. Both because of the cost of bankruptcies and limitations in the design of managerial incentive schemes, (105) firms typically act in a risk averse manner (106)--with risk being more than just a correlation with the business cycle. (107)

Moreover, with credit rationing (or the potential of credit rationing) not only does the firm's net worth (the market value of its assets) matter, but so does its asset structure, including its liquidity. (108) While there are many implications of the theory of the risk averse firm facing credit rationing, some of which are elaborated upon in the next section, one example should suffice to highlight the importance of these ideas. In traditional neoclassical investment theory, investment depends on the real interest rate, and the firm's perception of expected returns. The firm's cash flow or its net worth should make no difference. The earliest econometric studies of investment, by Kuh and Meyer [1957], suggested that that was not the case. But under the strength of the theoretical strictures that these variables could not matter, they were excluded from econometric analysis for two decades following the work of Hall and Jorgenson [1967]. It was not until work on asymmetric information had restored theoretical respectability to introducing such variables in investment regressions that it was acceptable to do so; and when that was done, it was shown that, especially for small and medium sized enterprises, these variables were crucial. (109)

Moreover, in the traditional theory, there is no corporate veil; individuals can see perfectly what is going on inside the firm; it makes no difference whether the firm distributes or retains its profits (other than for taxes). (110) But if there is imperfect information about what is going on inside the firm, then there is a corporate veil, which cannot be easily pierced.

Corporate governance

In the traditional theory, firms simply maximized the expected present discounted value of profits (which equaled market value) (111) and with perfect information, how that was to be done was simply an engineering problem. Disagreements about what the firm should do were of little importance. In that context, corporate governance--how firm decisions were made--mattered little as well. But again, in reality, corporate governance matters a great deal. There are disagreements about what the firm should do (112)--partly motivated by differences in judgments, partly motivated by differences in objectives. Managers can take actions which advance their interests at the expense of that of shareholders, and majority shareholders can advance their interests at the expense of minority shareholders. The owners (who, in the language of Steve Ross [1973] came to be called the principal) not only could not monitor their workers and managers (the agents), because of asymmetries of information, but also they typically did not even know what these people who were supposed to be acting on their behalf should do. That there were important consequences for the theory of the firm of the separation of ownership and control had earlier been noted by Berle and Means [1932], (113) but it was not until information economics that we had a coherent way of thinking about the implications.