Joseph Stiglitz: Nobel Prize ‘Information And The Change In The Paradigm In Economics’

Economics thinking has fundamentally shaped the world we live in today. Joseph Stiglitz is a well renowned US Economist who fearlessly has metaphorically identified the Emperor has no clothes. Meaning the unquestioned faith governments, academics and the business community have placed on market capitalism, is not the panacea to stable efficient societies. Moreover many policies and market behaviours have served to create greater divisions and market failures. Stiglitz was deeply concerned with social justice, a stark contrast from most economic commentary.

I would like to add that when I was studying Economics I had some fundamental reservations between the models I was taught and the real world experience. I remember having a cup of tea with one of my Professor’s and discussing with him the infinite growth modelling in a finite world and my concerns about the shortcomings of Economics such as unrealistic examples used to illustrate the model. He was aware. Perhaps unwittingly my time after university has led me to natural forces and the wisdom of allowing people to find what works and what doesn’t. To reconnect to our natures rather than educating us to be rational which is out of step with the natural system.

In the world we are in currently, it is very important in an engaged democracy that voices are not muzzled, that all viewpoints are heard. That we find the strength to not divide into ‘us and them’ of those to watch and those endorsed (in). It is to value the diversity of all of us and value the different perspectives. Each have ideas to contribute, none are meaningless in my mind. Democracy welcomes differences and learns from mistakes. Mistakes are not to be seen as failures but to be seen as opportunities to re-create what we actually want and what works in the best interests of the community. I note Stiglitz struggles with how to balance self interest and social interests as the highest payoff. Constantly economics is examining self interested behaviour that is viewed as rational.

This post will highlight features Joseph Stiglitz Nobel Prize Lecture, December 8, 2001. I have edited it as some of it is very heavy for the lay person and I would like to give you an insight into an Economist. It is worth reading and I have pasted those parts I felt were of great interest. If you want the full lecture then go to the link http://nobelprize.org/nobel_prizes/economics/laureates/2001/stiglitz-lecture.pdf (full lecture)

JOSEPH E. STIGLITZ

Columbia Business School, Columbia University, 1022 International Affairs Building, 420 West 118th Street, New York, NY 10027, USA.

The research for which George Akerlof, Mike Spence, and I are being recognized is part of a larger research program which, today, embraces hundred, perhaps thousands, of researchers around the world. In this lecture, I want to set the particular work which was sited within this broader agenda, and that agenda within the broader perspective of the history of economic thought. I hope to show that Information Economics represents a fundamental change in the prevailing paradigm within economics. Problems of information are
central to understanding not only market economics but also political economy, and in the last section of this lecture, I explore some of the implications of information imperfections for political processes.

INTRODUCTION

Many years ago Keynes wrote:

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood…Indeed, the world is ruled by little else. Practical men, who believe themselves quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. Keynes [1936].

Information economics has already had a profound effect on how we think about economic policy, and are likely to have an even greater influence in the future. The world is, of course, more complicated than our simple – or even our more complicated models – would suggest. Many of the major political debates over the past two decades have centered around one key issue: the efficiency of the market economy, and the appropriate relationship between the market and the government. The argument of Adam Smith [1776], the founder of modern economics, that free markets led to efficient outcomes,
“as if by an invisible hand” has played a central role in these debates: it suggested that we could, by and large, rely on markets without government intervention.

There was, at best, a limited role for government. The set of ideas that I will present here undermined Smith’s theory and the view of government that rested on it. They have suggested that the reason that the hand may be invisible is that it is simply not there – or at least that if is there, it is palsied. When I began the study of economics some forty one years ago, I was struck by the incongruity between the models that I was taught and the world that I had seen growing up, in Gary Indiana, a city whose rise and fall paralleled the rise and fall of the industrial economy. Founded in 1906 by U.S. Steel, and named after its Chairman of the Board, by the end of the century it had declined to but a shadow of its former self. But even in its heyday, it was marred by poverty, periodic unemployment, and massive racial discrimination. Yet the theories that we were taught paid little attention to poverty, said that all markets cleared – including the labor market, so unemployment must be nothing more than a phantasm, and that the profit motive ensured that there could not be economic discrimination.1 If the central theorems that argued that the economy was Pareto efficient – that, in some sense, we were living in the best of all possible worlds – were true, it seemed to me that we should be striving to create a different world. As a graduate student, I set out to try to create models with assumptions – and conclusions – closer to those that accorded with the world I saw, with all of its imperfections.

My first visits to the developing world in 1967, and a more extensive stay in Kenya in 1969, made an indelible impression on me. Models of perfect markets, as badly flawed as they might seem for Europe or America, seemed truly inappropriate for these countries. But while many of the key assumptions that went into the competitive equilibrium model seemed not to fit these economies well, the ones that attracted my attention was the imperfection of information, the absence of markets, and the pervasiveness and persistence of seeming dysfunctional institutions, like sharecropping. With workers having to surrender 50% or more of their income to landlords, surely (if conventional economics were correct), incentives were greatly attenuated.

Traditional economics said not only that institutions (like sharecropping)2 did not matter, but neither did the distribution of wealth. But if workers owned their own land, then they would not face what amounted to a 50% tax. Surely, the distribution of wealth did matter.

I had seen cyclical unemployment – sometimes quite large – and the hardship it brought as I grew up, but I had not seen the massive unemployment that characterized African cities, unemployment that could not be explained either by unions or minimum wage laws (which, even when they existed, were regularly circumvented). Again, there was a massive discrepancy between the models we had been taught and what I saw.

The new ideas and models were not only useful in addressing broad philosophical questions, such as the appropriate role of the state, but also in analyzing concrete policy issues. In the 70s, economists became increasingly critical of traditional Keynesian ideas, partly because of their assumed lack of micro-foundations. The attempts made to construct a new macro-economics based on traditional micro-economics, with its assumptions of well functioning markets, was doomed to failure. Recessions and depressions, accompanied by massive unemployment, were symptomatic of massive market failures. The market for labor was clearly not clearing. How could a theory that began with the assumption that all markets clear ever provide an explanation? If individuals could easily smooth their consumption by borrowing at safe rates of interest, then the relatively slight loss of lifetime income caused by an interruption of work of six months or a year would hardly be a problem; but the unemployed do not have access to capital markets, at least not at reasonable terms, and thus unemployment is a cause of enormous stress. If markets were perfect, individuals could buy private insurance against these risks; yet it is obvious that they cannot. Thus, one of the main developments to follow from this line of research into the consequences of information imperfections for the functioning of markets is the construction of macro economic models that help explain why the economy amplifies shocks and makes them persistent, and why there may be, even in competitive equilibrium, unemployment and credit rationing.

I believe that some of the huge mistakes which have been made in policy in the last decade, in for instance the management of the East Asia crisis or the transition of the former communist countries to a market, might have been avoided in there had been a better understanding of issues, like bankruptcy and corporate governance, to which the new information economics called attention. And the so-called Washington consensus policies3, which have predominated
in the policy advice of the international financial institutions over the past quarter century, have been based on market fundamentalist policies which ignored the information-theoretic concerns, and this explains at least in part their widespread failures.

Information affects decision making in every context – not just inside firms and households. More recently, I have turned my attention to some aspects of what might be called the political economy of information: the role of information in political processes, in collective decision making. For two hundred years, well before the economics of information became a subdiscipline within economics, Sweden had enacted legislation to increase transparency. There are asymmetries of information between those governing and those governed, and just as markets strives to overcome asymmetries of information, we need to look for ways by which the scope for asymmetries of information in political processes can be limited and their consequences mitigated…

I have already noted in the introduction that something was wrong – seriously wrong – with the competitive equilibrium models which represented the prevailing paradigm when we went to graduate school. It seemed to say that unemployment didn’t exist, that issues of efficiency and equity could be neatly separated, so that economists could neatly set aside problems of inequality and poverty as they went about their business of designing more efficient economic systems. But there were a host of other predictions, empirical puzzles, that were hard to reconcile with the standard theory: in micro-economics, there were tax paradoxes such as why did firms seemingly not take actions which minimized their tax liabilities, security market paradoxes, such as why did asset prices seem to exhibit such high volatility9, and behavioral puzzles, such as why did firms respond to risks in ways which were markedly different from that predicted by the theory.10 In macro-economics, the cyclical movements of many of the key aggregate variables, such as consumption,11 inventories, 12 real product wages13, real consumption wages14, and interest rates15 are hard to reconcile with the standard theory, and if the perfect market assumptions were even approximately satisfied, the distress caused by cyclical movements in the economy would be much less than seems to be the case.16

The problems that we saw with the models that we were taught was not only that they seemed wrong, but that they left a host phenomena and institutions unexplained – why were IPO’s typically sold at a discount? Why did equities, which provided far better risk diversification than debt, play such a limited role in financing new investment?17 There were, to be sure, some Ptolemaic attempts to defend and elaborate on the old model. Some, like George Stigler18, while recognizing the importance of information, argued that once the real costs of information were taken into account, even with imperfect information, the standard results of economics would still hold. Information was just a transactions cost. In the approach of many Chicago economists, information economics was like any other branch of applied economics; one simply analyzed the special factors determining the demand and supply for information, just as agricultural economics analyzed those factors affecting the market for wheat. For the more mathematically inclined, information could be incorporated into production functions of, say, goods by inserting an “I” for the input “information,” and I itself could be produced by inputs, like labor. Our analysis showed that that this approach was wrong, as were the conclusions derived from it.

Practical economists who could not ignore the bouts of unemployment which had plagued capitalism since its inception talked of the neoclassical synthesis: using Keynesian interventions to ensure that the economy remained at full employment, and once that was done, the standard neoclassical propositions would once again be true. But while the neoclassical synthesis19 had enormous intellectual influence, by the 1970s and 80s it came under attack from two sides. It was an assertion, not based on a coherent view of the economy. One side attacked the underpinnings of Keynesian economics, its micro-foundations; why would rational actors by out of equilibrium – with unemployment persisting – in the way that Keynes had suggested. This side effectively denied the phenomena which Keynes was attempting to explain.

Worse still, some saw unemployment as largely reflecting an interference (e.g. by government in setting minimum wages, or trade unions, in using their monopoly power to set too high wages) with the free workings of the market, with the obvious implication: unemployment would be eliminated if markets were made more flexible, that is unions and government interventions were eliminated. Even if wages fell a third in the Great Depression, they should have, in this view, fallen even more.

There was an alternative perspective (articulated more fully in Greenwald and Stiglitz, 1987a, 1988b): why shouldn’t we believe that massive unemployment was just the tip of the iceberg, of more pervasive market efficiencies that are harder to detect. If markets seemed to function so badly some of the time, certainly they must be malperforming in more subtle ways much of the time. The economics of information bolstered the latter view.

Similarly, given the nature of the debt contracts, the falling wages and prices led to bankruptcy and economic disruptions, actually exacerbating the economic downturn. Had there been more wage and price flexibility, matters might have been even worse. Moreover, neither government nor unions imposed the limitations on wage and price dynamics in many sectors of the economy; at the very least, those who argued that the problem was wage and price rigidities had to look for other market imperfections, and any policy remedy (including a call for greater flexibility) had to take those factors into account…

EFFICIENCY OF THE MARKET EQUILIBRIUM AND THE ROLE
OF THE STATE

Perhaps the most important single idea in economics is that competitive economies lead, as if by an invisible hand, to a (Pareto) efficient allocation of resources, and that every Pareto efficient resource allocation can be achieved through a competitive mechanism, provided only that the appropriate lump sum redistributions are undertaken. It is these (fundamental theorems) of welfare economics which provide both the rationale for the reliance on free markets, and the belief that issues of distribution can be separated from issues of efficiency, allowing the economist the freedom to push for reforms which increase efficiency, regardless of their seeming impact on distribution; if society does not like the distributional consequences, it should simply redistribute income.

The economics of information showed that neither of these results was, in general, true. To be sure, economists over the preceding three decades had identified important market failures – such as the externalities associated with pollution – which required government intervention.85 But the scope for market failures was limited, and thus the arenas in which government intervention was required were limited.

Early work, already referred to, had laid the foundations for the idea that economies with information imperfections would not be Pareto efficient, even taking into account the costs of obtaining information. There were interventions in the market that could make all parties better off. We had shown, for instance, that incentives for the disclosure and acquisition of information were far from perfect; imperfect appropriability meant that there might be insufficient incentives, but the fact that much of the gains were “rents,” gains by some at the expense of others, suggested that there might be excessive expenditures on information. One of the arguments for unfettered capital markets was that there were strong incentives to gather information; if one discovered that some stock was more valuable than others thought, if you bought it before they discovered the information, then you would make a capital gain. This price discovery function of capital markets was often advertised as one of its strengths. But the issue was, while the individual who discovered the information a nano-second before any one else might be better off, was society as a whole better off: if having the information a nano-second earlier did not lead to a change in real decisions (e.g. concerning investment), then it was largely redistributive, with the gains of those obtaining the information occurring at the expense of others. Another example illustrates what is at issue. Assume hundred dollar bills were to fall, one each at the left foot of each student in my class. They could wait to the end of the lecture, then pick up the money; but that is not a Nash equilibrium. If all students were to do that, it would pay any one to bend down and quickly scoop up what he could. Each realizing that immediately picks up the dollar bill at his foot. The equilibrium leaves each no better off than if he had waited – and there was a great social cost, the interruption of the lecture.

There are potentially other inefficiencies associated with information acquisition. Information can have adverse effects on volatility87. And information can lead to the destruction of markets, in ways which lead to adverse effects on welfare. We described earlier how the existence of asymmetries of information can destroy markets. Individuals sometimes have incentives to obtain information (creating an asymmetry of information), which then leads to the destruction of insurance markets, and an overall lowering of welfare. Welfare might be increased if the acquisition of this kind of information could be proscribed. Recently, such issues have become sources of real policy concern, in the arena of genetic testing. Even when information is available, there are issues concerning its use, with the use of certain kinds of information having either a discriminatory intent or effect, in circumstances in which such direct discrimination itself would be prohibited….

CONCLUDING REMARKS

In this talk I have traced the replacement of one paradigm with another. The deficiencies in the neoclassical paradigm – both the predictions which seemed counter to what was observed, some so glaring that one hardly needed refined econometric testing, and the phenomena that were left unexplained – made it inevitable that it was simply a matter of time before it became challenged. One might ask, how can we explain the persistence of the paradigm for so long? Partly, it must be because, in spite of its deficiencies, it did provide insights into many economic phenomena. There are some markets in which the phenomena which we have discussed are not important – the market for wheat or corn – though even here, pervasive government interventions make the reining competitive paradigm of limited relevance. The underlying forces of demand and supply are still important, though in the new paradigm, they become only part of the analysis; they are not the whole analysis. But one cannot ignore the possibility that the survival of the paradigm was partly because the belief in that paradigm, and the policy prescriptions, has served certain interests.

As a social scientist, I have tried to follow the analysis, wherever it might lead. As any researcher, we know that our ideas can be used or abused – or ignored. Understanding the complex forces that shape our economy is of value in its own right; there is an innate curiosity about how this system works. But “All the world’s a stage, and all the men and women merely players” Shakespeare [1599]. Each of us in our own way, if only as voters, is actor in this grand drama. And what we do is affected by our perceptions of how this complex system works.

I entered economics with the hope that it might enable me to do something about unemployment, poverty, and discrimination. As an economic researcher, I have been lucky enough to hit upon some ideas that I think do enhance our understanding of these phenomena. As an educator, I have been lucky enough to have had the opportunity to reduce some of the asymmetries of information, especially concerning what the new information paradigm and other developments in modern economic science have to say about these phenomena, and to have had some first rate students who themselves have pushed the research agenda forward.

As an individual, I have however not been content just to let others translate these ideas into practice. I have had the good fortune to be able to do so myself, as a public servant both in the American government and at the World Bank. We have the good fortune to live in democracies, in which individuals can fight for their perception of what a better world might be like. We as academics have the good fortune to be further protected by our academic freedom. With freedom comes responsibility: the responsibility to use that freedom to do what we can to ensure that the world of the future be one in which there is not only greater economic prosperity, but also more social justice.