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

American Economist, Spring, 2004 by Joseph E. Stiglitz

The theory has important policy implications. It provides a new basis for a "liquidity trap," explaining why in severe economic downturns, monetary policy may be relatively ineffective. It explains some of the recent policy failures, both in the inability of the Fed to forestall the 1991 recession and the failures of the IMF in East Asia in 1997. It shifts emphasis from looking at the Fed Funds rate, or the money supply, to variables of more direct relevance to economic activity, the level of credit, (124) and the interest rates charged to firms (and it explains the movement in the spread between that rate and the Federal Funds rate). The theory predicts that there is scope for monetary policy even in the presence of dollarization. (125)

We also analyzed the importance of credit interlinkages. Many firms receive credit from other firms, at the same time that they provide credit to still others (violating Polonius' injunction "neither a lender nor a borrower be" by being both.) The disperse nature of information in the economy provides an explanation of this phenomena, which has important consequences. As a result of these general interlinkages (in some ways, every bit as important as the commodity interlinkages stressed in standard general equilibrium analysis) a shock to one firm gets transmitted to others, and when there is a large enough shock, there can be a cascade of bankruptcies.

Growth (126) and development (127)

While most of the macro-economic analysis focused on exploring the implications of imperfections of credit markets arising out of information problems for cyclical variations, another strand of our research program focused on growth. The importance of capital markets for growth had long been recognized; without capital markets firms have to rely on retained earnings. But how firms raise capital is important for growth. In particular, "equity rationing"--especially important in developing countries, where informational problems are even greater--impedes firms' willingness to invest and undertake risks, and thus slows down growth. Changes in economic policy which enable firms to bear more risk (e.g. by reducing the size of macroeconomic fluctuations, or which enhance firms' equity base, by suppressing interest rates, which result in firm's having larger profits) enhance economic growth. Conversely, policies, such as associated with IMF interventions, in which interest rates are raised to very high levels, discourage the use of debt, forcing firms to rely more heavily on retained earnings.

The most challenging problems for growth lie in economic development. Typically, market failures are more prevalent in less developed countries, and these market failures are often associated with information problems--the very problems that inspired much of the research described in this paper. While these perspectives help explain the failures of policies based on assuming perfect or well functioning markets, they also direct attention to policies which might remedy or reduce the consequences of informational imperfections. (128)