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

American Economist, Spring, 2004 by Joseph E. Stiglitz

Even when the shocks were not large enough to lead to bankruptcy, they had impacts on firms' ability and willingness to take risks. Since all production is risky, shocks affect aggregate supply, as well as the demand for investment. Because firm's net worth would only be restored over time, the effects of a shock persisted. By the same token, there were hysteresis effects associated with policy: an increase in interest rates which depleted firm net worth had impacts even after the interest rates were reduced. If firms were credit rationed, then reductions in liquidity could have particularly marked effects. (120) Every aspect of macro-economic behavior was affected: the theories helped explain, for instance, the seemingly anomalous behavior of inventories (rather than using inventories to smooth production, which would result in countercyclical changes in inventories, inventories moved procyclically, because of the importance of cash constraints, leading to a high shadow price of money in recessions) and pricing (with the "shadow price" of capital being high in a recession, firms did not invest as much in acquiring new customers and were less concerned about losing workers, so that mark-ups increased, so that real product wages could fail, even though the marginal productivity of labor was rising.)

In short, our analysis emphasized the supply side effects of shocks, the interrelationships between supply and demand side effects, and the importance of finance in propagating fluctuations.

Theory of money (121)

A particularly important aspect of our reformulation of macro-economics is the focus on monetary economics. Traditionally, it was postulated that the interest rate was set to equate the demand and supply for money, with money being largely required for transactions purposes, and with the interest rate representing the opportunity cost of money. In modern economies, however, credit, not money, is required (and used) for most transactions, and most transactions are simply exchanges of assets, and therefore not directly related to DP. Moreover, today, most money is interest bearing, with the difference between the interest rate paid, say on a money market account and T bill rates having little to do with monetary policy, and related solely to transactions costs. What is important is the availability of credit (and the terms at which it is available); this in turn is related to the certification of credit worthiness by banks and other institutions. In short, information is at the heart of monetary economics. But banks are like other risk averse firms: their ability and willingness to bear the risks associated with making loans depends on their net worth. (122) Because of equity rationing, shocks to their net worth cannot be instantaneously undone, and the theory thus explains why such shocks can have large adverse macro-economic consequences. The theory shows how not only traditional monetary instruments (like reserve requirements) but regulatory instruments (like risk adjusted capital adequacy requirements) can be used to affect the supply of credit, interest rates charged, and the bank's risk portfolio. The analysis also showed how excessive reliance on capital adequacy requirements could be counterproductive. (123)