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

American Economist, Spring, 2004 by Joseph E. Stiglitz

Macro-economics

The central macro-economic issue is that of unemployment. The models I described earlier explained why there could exist unemployment in equilibrium. But much of macro-economics is concerned with dynamics, with fluctuations, with explaining why sometimes the economy, rather than absorbing shocks, seems to amplify them, and why their effects often persist. In joint work with Bruce Greenwald and Andy Weiss, we have shown how the theories of asymmetric information can help provide explanations of these macro-economic phenomena. The imperfections of capital markets--the phenomena of credit and equity rationing which arise because of information asymmetries--are key. They lead to risk averse behavior of firms and to households and firms being affected by cash flow constraints.

Standard interpretations of Keynesian economics emphasized the importance of wage and price rigidities, but without a convincing explanation of those rigidities. For instance, some theories had stressed the importance of costs of adjustment of prices," (116) but what was at issue was why markets seemed to adjust quantities rather than prices, and the relative costs of adjustment of quantities seemed greater than those of prices. The Greenwald-Stiglitz theory of adjustment [1989b] provided an explanation based on capital market (117) imperfections arising from information imperfections: it argued that, at least for commodities for which inventory costs were reasonably low, the risks arising from informational imperfections were greater for price and wage adjustments than from quantity adjustments. Risk averse firms would make smaller adjustments to variables, the consequences of which were more uncertain.

But even though wages and prices were not perfectly flexible, neither were they perfectly rigid, and indeed in the Great Depression, they fell by a considerable amount. There had been large fluctuations in earlier periods, and in other countries, in which there had been a high degree of wage and price flexibility. Greenwald and I [1987a, 1987b, 1988b, 1988c, 1988d, 1988e, 1989b, 1990b, 1993a, 1993b, 1995] argued that it was other market failures, in particular, the imperfections of capital markets and the incomplete contracting which provided part of the explanation for key observed macro-economic phenomena. In debt contracts, typically not indexed for changes in prices, whenever prices fell below the level expected (or in variable interest rate contracts, when real interest rates rose above the level expected) there were transfers from debtors to creditors. In these circumstances, excessive downward price flexibility (not just price rigidities) could give rise to problems. (118) These (and other) redistributive changes had large real effects, and could not be insured against because of imperfections in capital markets. Large shocks could lead to bankruptcy, and with bankruptcy (especially when it results in firm liquidation) there was a loss of organizational and informational capital. (119) Even if such large changes could be forestalled, until there was a resolution, the firm's access to credit would be impaired, and for good reason; moreover, without "clear owners" those in control would in general not have incentives to maximize the firm's value.