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TowardsaGeneralTheoryofDeepDownturns

JosephE.Stiglitz1
Theworldhasbeenplaguedbyepisodicdeepdownturns.Thecrisisthatbeganin2008intheUnited
Stateswasthemostrecent,thedeepestandlongestinthreequartersofacentury.Itcameinspiteof
allegedbetterknowledgeofhowoureconomicsystemworks,andbeliefamongmanythatwehadput
economicfluctuationsbehindus.OureconomicleaderstoutedtheachievementoftheGreat
Moderation.2Asitturnedout,beliefinthosemodelsactuallycontributedtothecrisis.Itwasthe
assumptionthatmarketswereefficientandselfregulatingandthateconomicactorshadtheabilityand
incentivestomanagetheirownrisksthathadledtothebeliefthatselfregulationwasallthatwas
requiredtoensurethatthefinancialsystemworkedwell,andthattherewasnoneedtoworryabouta
bubble.Theideathattheeconomycould,throughdiversification,effectivelyeliminateriskcontributed
tocomplacencyevenafteritwasevidentthattherehadbeenabubble.Indeed,evenafterthebubble
broke,Bernankecouldboastthattheriskswerecontained.3Thesebeliefsweresupportedby(precrisis)
DSGEmodelsmodelswhichmayhavedonewellinmorenormaltimes,buthadlittletosayabout
crises.Ofcourse,almostanydecentmodelwoulddoreasonablywellinnormaltimes.Andit
matteredlittleif,innormaltimes,onemodeldidaslightlybetterjobinpredictingnextquarters
growth.Whatmattersispredictingandpreventingcrises,episodesinwhichthereisanenormous
lossinwellbeing.Thesemodelsdidnotseethecrisiscoming,andtheyhadgivenconfidencetoour
policymakersthat,solongasinflationwascontainedandmonetaryauthoritiesboastedthattheyhad
donethistheeconomywouldperformwell.Atbest,theycanbethoughtofas(borrowingtheterm
fromGuzman(2014)modelsoftheGreatModeration,predictingwellsolongasnothingunusual
happens.Moregenerally,theDSGEmodelshavedoneapoorjobexplainingtheactualfrequencyof
crises.4

PresidentialAddresstothe17thWorldCongressoftheInternationalEconomicCongress,DeadSea,Jordan
June,2014.ThisaddressisbasedinpartonjointworkwithBruceGreenwaldandMartinGuzman.Helpful
discussionswithAdairTurner,particularlyonPartIII,andwithRobJohnson,MartinGuzman,andArjunJayadev,
aregratefullyacknowledged.IamindebtedtoINETforfinancialsupport,andtoFeiranZhang,DebaratiGhoshand
RuokeYangforresearchassistance.Thefirsttwopartsofthislectureareadevelopmentofideaspresentedearlier
inStiglitz(2011,2013).Foramoreextensivelistofreferences,seethosepapers.
2
McConnellandPerezQuiros(2000)wereamongthefirstonestoidentifytheGreatModeration,whichthey
attributedtochangesininventorymanagement.Indeed,inhispresidentialaddresstotheAEA,Lucas(2003)went
ontodescribehowthecentralproblemofdepressionpreventionhasbeenlargelyresolved.Hisconclusionwas
obviouslywrong.Sotoo,IsuspectwerethoseattributingtheGreatModerationtobettermanagementbythe
CentralBank(oreventobetterinventorymanagement).Inflationwastamedinpartbytheincreasingsupplyof
consumergoodsatlowpricescomingfromChina.Withthedeclineinthemanufacturingsector,inventorieshad
simplybecomelessimportant.Finally,therewasanelementofgoodluck:therewasnothingcomparabletothe
oilpriceshocksofthe70swithwhichCentralBankshadtocontend.
3
OnMarch28th2007intestimonybeforetheUSCongress,afterthebubblehadalreadybroken,the
FedChairmanasserted:theimpactonthebroadereconomyandfinancialmarketsoftheproblemsinthe
subprimemarketseemslikelytobecontained.
4
SeeGuzman(2013),whoexplainstheflawsintheresultsofAguiarandGopinath(2006)whohadamore
optimisticviewoftheabilityofsuchmodelstoexplainthefrequencyofcrises.

Ofcourse,deepdownturnshavemarkedcapitalisteconomiessincethebeginning.Ittookenormous
hubristobelievethattheeconomicforceswhichhadgivenrisetocrisesinthepastwereeithernot
present,orhadbeentamed,throughsoundmonetaryandfiscalpolicy.5Ittookevengreaterhubris
giventhatinmanycountriesconservativeshadsucceededindismantlingtheregulatoryregimesand
automaticstabilizersthathadhelpedpreventcrisessincetheGreatDepression.Itisnoteworthythat
myteacher,CharlesKindleberger,inhisgreatstudyoftheboomsandpanicsthatafflictedmarket
economiesoverthepastseveralhundredyearshadnotedsimilarhubrisexhibitedinearliercrises.
(Kindleberger,1978)
Thosewhoattemptedtodefendthefailedeconomicmodelsandthepolicieswhichwerederivedfrom
themsuggestedthatnomodelcould(orshould)predictwellaonceinahundredyearflood.Butit
wasnotjustahundredyearfloodcriseshavebecomecommon.Itwasnotjustsomethingthathad
happenedtotheeconomy.Thecrisiswasmanmadecreatedbytheeconomicsystem.Clearly,
somethingiswrongwiththemodels.
Studyingcrisesisimportant,notjusttopreventthesecalamitiesandtounderstandhowtorespondto
themthoughIdobelievethatthesameinadequatemodelsthatfailedtopredictthecrisisalsofailedin
providingadequateresponses.(AlthoughthoseintheUSAdministrationboastabouthavingprevented
anotherGreatDepression,Ibelievethedownturnwascertainlyfarlonger,andprobablyfardeeper,
thanitneedtohavebeen.)Ialsobelieveunderstandingthedynamicsofcrisescanprovideusinsight
intothebehaviorofoureconomicsysteminlessextremetimes.
Thislectureconsistsofthreeparts.Inthefirst,Iwilloutlinethethreebasicquestionsposedbydeep
downturns.Inthesecond,Iwillsketchthethreealternativeapproachesthathavecompetedwitheach
otheroverthepastthreedecades,suggestingthatoneisafarbetterbasisforfutureresearchthanthe
othertwo.ThefinalsectionwillcenterononeaspectofthatthirdapproachthatIbelieveiscrucial
credit.Ifocusonthecapitalisteconomyasacrediteconomy,andhowviewingitinthiswaychangesour
understandingofthefinancialsystemandmonetarypolicy.

I.

Threefundamentalquestions

Economicsystemshavealwaysexhibitedvolatility,andeconomictheoristshavelongsoughttodescribe
andexplainthesefluctuations.IntheUnitedStates,theNationalBureauofEconomicResearchbegan
asanattempttocharacterizeanddatebusinesscycles(forinstance,withtheworkofWesleyMitchell
andhisstudent,SimonKuznets).Inthemiddleofthetwentiethcentury,anumberoftheories
explainingwhymarketsendogenouslygiverisetocyclicalfluctuationsweredeveloped.Particular

Thiskindofhubriswasnotonlyexhibitedbypolicymakers,butalsobyacademics.RobertLucas,inhis
presidentialaddresstotheAmericanEconomicAssociation,famouslysaid:,[The]centralproblemofdepression
preventionhasbeensolved,forallpracticalpurposes,andhasinfactbeensolvedformanydecades.(Lucas,
2003)

attentionwaspaidtoinventorycycles.Butmuchofthisliteraturewasconcernedwithsmall
oscillations,notthedeepdownturnsthatarethefocusofthislecture.
A. Whatisthesourceoflargeperturbations?
Thekeyquestionsare:Isthesourceofthosemajorperturbationsexogenousorendogenous?Andhow
doeconomicstructuresandpoliciesaffectthedepthanddurationoftheseperturbations?
Thestandardmodels(referredtoearlierintheintroduction,anddiscussedatgreaterlengthbelow)
assumethatthesourceofthedisturbancestotheeconomyisexogenous.Tome,itisclearthatthatis
simplywrong:thecreditandhousingbubblethatwereatthecenterofthe2008crisiswascreatedby
themarket.Thebubblewasamarketphenomenon.Toassumethatitwasexogenousistoassumethat
thereisnothingthatwecandoeithertopreventthecreationofabubbleortocurtailitssize.
Equallytroublesome,muchoftheliteraturereferredtobelowassumesthattheshockstotheeconomic
systemaretechnologyshocks.AsIexplainbelow,whenwelookatmanyofthekeyeconomic
fluctuations,itishardtoseeanychangestotechnologythatcouldhavegeneratedsuchchanges.
Bythesametoken,oneofthereasonsthatthecrisisspreadsoquicklyandvirulentlybeyondthe
bordersoftheUnitedStateswasglobalization6theresultofpoliciesthathadbeenpursuedoverthe
previousquarterofacenturythatresulted,forinstance,inmuchgreaterfinancialintegration.Again,it
issimplywrongtoassumethattheshocksconfrontingacountryareexogenous:eveniftheoriginof
shockswereexogenous,theextenttowhichacountryisexposedtoshocksisendogenous.(Indeed,in
thecaseofdevelopingcountries,thereisawealthofevidencethatmostoftheshockstotheir
economiescomefromoutsidetheirborders.)7
B.Howcanweexplainmagnitudeofvolatility?
Thechangeinthephysicalstatevariablesistypicallysmall,andyet,indeepdownturns,thechangein
outputandemploymentaretypicallylarge.Considerthe2008crisis.Therewasnodestructionof
physicalorhumancapital,asoftenhappensinwarorinanaturaldisaster.Yettherewerehugechanges
inthelevelofmacroeconomicactivity,correspondingtolargechangesinthebehaviorofhouseholds
andfirms.
Inmanycases,shocksseemtohavebeenamplified,ratherthanbuffered,assuggestedbytraditional
economicmodels,wherepriceadjustmentsandinventorieshelpabsorbshocksanddampenthesizeof
fluctuations.
Earlierliterature(theSamuelsonacceleratormultipliermodel)triedtoexplainamplificationthroughan
investmentaccelerator:anincreasein(expected)growthleadstoanincreaseinthedemandfor
investmentgoods(toproducethelargeroutput),whichthenamplifiesgrowthitself.Butinthe
aftermathoftherationalexpectationsrevolution,itappearedhardtoreconcilesuchbehaviorandthe

6
7

MendozaandQuadrini(2009).
Forinstance,PopovandUdell(2010).

cyclestowhichtheacceleratormultipliermodelgaverisewithrationalexpectations.Forinstance,in
onevariantofthesemodels,atsomepointtheeconomyreachedfullemployment.Thisconstrained
growth.Butpriortothatconstraintbinding,investorsshouldhaverealizedthatthiswouldoccur;and
thiswouldhaveconstrainedinvestmentintheseearlierperiods.
ButGreenwaldandStiglitz,inaseriesofpapersbeginninginthe1980s8,andBernankeandGertler
(1990)showedthatimperfectinformationincapitalmarketsgaverisetoafinancialaccelerator.9In
particular,GreenwaldandStiglitz(1993a)explainedhowshockstoafirmsequitybase(resultingfroma
shocktothedemanditfaced,arisingfromanysource)leadtoreductionsinbothdemandandsupply,its
demandforinvestmentgoodsanditswillingnesstoproduceanditsemployment.Therewasan
acceleratoreffect.Theeffectsofshockswereamplified,notdampened.GreenwaldandStiglitz(1991,
2003a)showfurtheramplificationeffectsthroughsimilardisturbancestobanksbalancesheets,
resultinginpotentiallylargechangesinthesupplyofcreditandthetermsatwhichitismadeavailable
throughthebankingsystem.
C. Howdoweexplainpersistence?
Thethirdquestionis,howdoweexplainthepersistenceoftheeffectsofashock?Howdoweexplain
thataftertheonsetofadeepdownturn,outputandemploymentremainlow?ThelossesinGDPafter
the2008crisishavebeenfargreaterthanthoseassociatedwiththemisallocationofresourcesbefore
crisis,astheeconomyremainedmarkedlybelowthecrisislevelanditsprecrisistrendgrowthforalong
period.10Yet,therearethesamerealassets(physical,human,naturalcapital)afterthecrisisasbefore.
Morerecently,intheaftermathofthe2008crisis,manyhavereferredtotheexcessleverageinthe
economy.Butevendebtshouldntmatter:standardGeneralEquilibriumtheorysaysthatthereisa
marketclearingcompetitiveequilibriumwithfullemployment.Debtsimplyisamatterofwhohas
claimsonsocietysresources.Thereisnothinginstandardequilibriumtheorythatsaysthatthereare
patternsofownershipclaimsthatareinconsistentwithfullemployment.
Itshouldbeclearthatthesourceofpersistenceisnotinthecapitalstockorlaborsupply(though
eventually,extendedperiodsofunemploymentdohaveeffectsonhumancapitalandextended
recessionsanddepressionsdohaveeffectsonthestockofphysicalcapital).Thereispersistencein
unemploymentandexplainingwhytheeconomydoesnotquicklyreturntofullemploymentiskey.
TheZeroLowerFoundisNottheProblem

GreenwaldandStiglitz(1987b,1988a,c,d,1990,1993a,2003),basingtheirworkonmodelsofcreditandequity
rationing(StiglitzandWeiss,1981,1983;Greenwald,Stiglitz,andWeiss,1984).
9
Thevariousmodelsassumesomewhatdifferentfinancialfrictions,i.e.somefocusonborrowingconstraints
arisingfromcostlystateverification(Townsend1979),othersfromthoseassociatedwithadverseselectionand
moralhazard.GreenwaldandStiglitzintheirseriesofpapersalsofocusonthoseassociatedwithequitymarkets.
Therecanbemarkeddifferencesinresults,asweshallcommentbelow.Thus,resultsbasedonmodelswithcostly
stateverificationmaynotextendtootherformsoffinancialfrictions.
10
Infact,asthispapergoestopress,inmanyEuropeancountries,thelevelofGDPpercapitaisbelowthepre
crisislevel,andevenintheUnitedStatesandthebestperformingEuropeancountries,GDPremainsmarkedly
belowthelevelitwouldhavebeenhadtrendgrowthcontinued.(SeeStiglitz(2015c))

Recentdiscussionshavefocusedonthezerolowerboundtheinabilitytolowernominalinterestrates
belowzero.Ibelievetheexplanationdoesnotlie(ordoesnotliejust)inthezerolowerbound(ZLB).
The2008crisiswas,inthisrespect,markedlydifferentfromtheGreatDepression,whenpriceswere
fallingatanannualrateof10%.Thenazeronominalinterestratemeantarealinterestrateoften
percent,enoughtodiscourageinvestment.11Intherecentcrisis,priceswereincreasingataround2
percent,sothezerolowerboundmeantanegativerealinterestrateof2percent.Somearguedthatif
onecouldincreaseinflationaryexpectationssaybycommittingtoaninflationtargetof4%wecould
lowertherealinterestrate,saytominus4percent.Neithertheorynorevidencesuggeststhatsucha
changeintherealinterestratewouldhaverestoredtheeconomytofullemploymentevenifone
couldhavecrediblycommittedtomaintaininginflationat4%.(Moreover,iftheunderlyingproblemwas
theinabilitytochangeintertemporalpricesthroughmonetaryprices,therewasanalternative:
changingthemthroughtaxes,e.g.throughascheduleofchanginginvestmenttaxcreditsand
consumptiontaxrates.)
ButevenifpartofthefailureoftheeconomytoberestoredtofullemploymentdidlieintheZLB,itis
criticaltounderstandwhatgivesrisetotheZLBproblem.Clearly,theunderlyingproblemisthelackof
aggregatedemand,theresultofliquiditytheabilitytospendincomebeinginthehandsofthosewho
dontwanttospend(orconsume).Beforethecrisis,thebottom80%ofAmericanswerespending
110%oftheirincome(onaverage).Thiswaspossiblebecausebankswererecklessintheirlending;they
believedtoothatthemarketvalueofhousesrepresentedtheirtruevalue,sothatlendingagainstthis
collateralwassafe.Withthebreakingofthebubble,thewillingnessofbankstolenddecreased.Sotoo
didtheirability,withthemarkeddecreaseinthevalueoftheirnetworth.Sotoodidthewillingnessof
householdsandfirmstoborrow,astheysawtheirbalancesheetscontract.(Alloftheseeffectshad
beenearlieranalyzedinGreenwaldandStiglitz,1993a,2003.)Asweshallseeinthesubsequent
discussion,ifmodelsareconstructedinwhichtheeconomywillalwaysbeatfullemploymentinthe
futureandtherearenodistributionaleffects,thenthepossibilitiesforstimulatingtheeconomytodayis
constrained:morespendingtodaycanonlybeinducedbychangingintertemporalprices.12
Pseudowealth
GuzmanandStiglitz(2014,2015a,2015b)haveprovidedanotherexplanation:beforethecrisis,
differencesinviews,e.g.aboutthelikelihoodofthehousingbubblebreaking,gaverisetobets
(speculation),whichledtothecreationofpseudowealthwithbothsidestothebetbelievingthatthey
weregoingtowin,bothbelievedthattheywerewealthy,ormoreprecisely,theaggregateperceptionof
wealthwasgreaterthantruewealth.Afterthecrisis,pseudowealthgotdestroyed.Indeed,therewas

11

Thesenumbers,however,obscureimportantaggregationproblems.Thedeclineintheconsumerpriceindex
waslargelyaresultofenormousdeclinesinagriculturalpricesand,toasomewhatlesserextent,housingprices.
Manufacturedgoodspricesdeclined,buttoamuchlesserextent.SeeGreenwaldandStiglitz(1987b).
12
Asalwaysincomplexintertemporalmodels,thingsareneverquitesosimple:iftherewerevariationsinfuture
laborsupply,itispossiblethattherecouldstillbechangesinlifetimeincomewithoutchangesintheinterestrate.
Thatmightbethecase,forinstance,ifthegovernmentprovidedapublicgoodwhichwascomplementarywith
privateconsumptionandasubstituteforleisure.Thestandardmodels,however,donotallowforsuchsubtleties.

evennegativepseudowealth:borrowersmayhavebelievedthatwhattheywouldpay,inexpected
valueterms,tothelenderswasgreaterthantheleadersbelievedthattheywouldreceive.
Dynamicsofadjustment
Iftherealwealthoftheeconomyafterthecrisisisnotmuchdifferentfromthatbeforethecrisis,ifthe
marketequilibriumdependedonlyoncriticalaggregatestatevariableslikethestateoftechnology,
capitalstock,naturalresources,andtheamountofhumancapital13,thenthefullemployment
equilibriumafterthecrisiswouldnotbemuchdifferentfromthatbefore.Thus,themagnitudeof
adjustmentsinwagesandpricesthatwouldberequiredtoattainfullemploymentwouldnotbethat
different;andwithsomedegreeofwageandpriceflexibility,fullemploymentshouldquicklybe
restored.Butiftheeconomybeforethecrisiswassupportedbyabubbleorpseudowealthorifthere
arelargedistributionaleffects14thentherecanbelargechangesinaggregatedemandatthepreviously
prevailingwagesandprices;andtorestoretheeconomytofullemploymentwouldrequirelarge
changesinwagesandprice.
Butatleastintheshortrun,thesewageandpriceadjustmentsinadecentralizedmarketeconomycan,
bedestabilizing.Unemployment,anexcesssupplyoflabor,leadstolowerwages,whichreduces
aggregatedemand.Suchchangesareredistributive,buttheincreaseinspendingoutoftheincreasein
profitsislessthanthedecreaseinspendingbyworkers;andthisisespeciallysoiftheyworryabouttheir
futureincomeandfaceborrowingconstraints.Defaultsandexpecteddefaultsassociatedwith
deflationbecausedebtcontractsarenotindexedworsenbanksbalancesheets,andleadtoa
contractioninlending.15
Finally,ananalysisofdeepdownturnshastobebasedonanunderstandingofwhythereissuch
sufferingassociatedwiththem.Ifthedecreaseinhoursworkedwereevenlyshared,iftherewerefull
intertemporalandinterstatesmoothing,andifcriseswerenotsopersistent,thenthesocialcostof
economicfluctuationswouldbemuchless.Eveninthedeepestofdownturns,sayinGreeceinthe
aftermathoftheEurocrisis,outputfellonlyaround25%.Ifthedownturnlastedonlyacoupleofyears,
areductionof25%fortwoyearsoutofaworkinglifeof40years,atalowdiscountratewouldamount

13

Evenwiththesamepeoplewiththesameeducation,thevalueofhumancapitalcanbelowerafterthecrisis,as
thestructureoflabordemandmaychange.Differencesinskillsreinforcestheinsightsofpseudowealththeory:
agentAthinksthereturnonactivityXisrelativelarge,comparedtothereturnonactivityY;agentBhasjustthe
oppositeview.Theshockmaychangetheirvaluationsinwayswhichresultinasignificantdecreaseinaggregate
demand(atanysetofwagesandprices).
14
Thelaterdiscussionwillidentifyseveralotherreasonswhytheremaybelargechangesinaggregatedemand.
15
Thisispartlyaresultofthefactthatbankruptciessarecostlytheyarenotjustredistributiveandpartlya
matterofaccountingandregulation:withmarktomarketaccounting,anincreaseinbankruptcyprobabilitylowers
banksnetworth,andforcesacutbackinlendingoranincreaseinequity.Butdeepdownturnsarenotagood
timetoraiseequity;existingshareholdersarelikelytofeelthattherewillbeexcessivedilutionoftheirownership
claims.Theydonottakeaccountofthemacroeconomicexternalitiesassociatedwiththecontractionintheir
lending(justastheydonottakeaccountofthemacroeconomicexternalitiesassociatedwiththeirexcessive
lendingintherunuptothecrisis).Butevenintheabsenceoftheseaccountingandregulatoryconstraints,the
diminutioninbanknetworthwouldleadtoacontractioninlending,morethanoffsettingtheimprovementinthe
balancesheetofthedebtorsasaresultofthedischargeintheirdebts.

toareductioninlifetimeincomeofonlyaround1.25%andmostindividualscouldeasilyabsorbsucha
change.But,ofcourse,noneoftheseassumptionsareaccurate:thereductioninhoursworkedisnot
equallysharedsomeindividualsbecomeunemployed,whileothersexperienceonlyaslightreduction
inhoursworked;capitalmarketsdonotalloweasyintertemporalsmoothing;thereisnoprivatemarket
forinterstatesmoothingandunemploymentinsuranceprovidesonlylimitedinsurance.16And,ifthere
ismeanreversion,itislimited:withdeepdownturns,thelossesinoutputoftenappearpermanent,
withgrowthinthefutureoccurringoffofadiminishedbasis,andwithhysteresiseffectsevenaffecting
growthrates(e.g.becauseofthediminutionofhumancapital,aresultofthelowerjobexperiencesof
youngpeople).Thus,anymeaningfultheoryofdeepdownturnsmustcometotermswiththesecritical
aspectsofmarketsandmarketdynamics;Lucas(1987)failuretodosoexplainswhyhehasgrossly
underestimatedthesocialcostsofeconomicfluctuations.
II.
Threestrandsoftheory
Inthispartofthelecture,Iwilllookatthethreemajorstrandsofmodernmacroeconomicsreal
businesscycles(andrelatedwork);newKeynesiantheorieswithrigidwagesandprices;andalternative
strandsofNewKeynesianeconomics,basedontheworkofIrvingFisher(1933)andGreenwaldStiglitz.
Whileeachmayhaveworkedtohelpexplaindifferenthistoricalepisodes(oilpriceshocks,theGreat
Moderationandtheearly90s),Iwillarguethatonlythethirdprovidesaconvincinginterpretationof
deepdownturns,suchastheGreatDepressionandtheGreatRecession.Afterpresentingthesethree
strands,Iwillillustratethedifferencesbycontrastingsomekeypolicyrecommendations.
A.Realbusinesscycles(andrelatedwork)(1stgenerationDSGEmodels)(RBC)
Theassumptionsunderlyingthiswork,whichdominatedmacroeconomicanalysisinmuchofthelatter
partofthetwentiethcentury,aresufficientlywellknownthatIdonothavetorecountthemhere.Iwill
focusmyattentiononthosewhichIbelievearecentraltothesemodelsfailuretoprovideinsightsinto
deepdownturns.Amongthecriticalassumptionsare:(a)exogenousshocks;(b)perfectlyflexiblewages
andprices,whichmeansthatallmarketsclearthereis,inparticular,alwaysfullemployment(though
theremaybevariationsinthehoursworked);(c)theperfectlyflexiblepricesystem,togetherwith
inventories,dampensshocks(sothatinventoriesarecountercyclical);(d)allmarketparticipantshave
rationalexpectations;andthereiscommonknowledge.Thereis,ofcourse,stilluncertainty;butthereis
nolearninginthewaythatlearningisusuallydefinedandindividualshavenothingtolearnfrom
eachother.17Thereare,ofcourse,nobettingmarketssinceindividualsallagreeaboutthe
probabilitiesofallevents.
Fullequilibrium,withnounemployment
Undertheassumptionsofthemodel,theeconomyisalwaysinequilibriummarketactsasifthere
werefuturesmarketsgoingoutinfinitelyfarintothefutureandasiftherewereacompletesetof

16

SeeStiglitzandYun(2005,2013,2014)foramoreextensivediscussionofthelimitsontheabilityofinsurance
andloanstoachievefullinterstateandintertemporalsmoothing.
17
Ofcourse,intheabsenceofuncertainty,thereisnothingtolearn.Withuncertainty,thereis,inprinciple,
somethingthatcouldbelearned(e.g.formingbetterestimatesoffuturevariables),butthepossibilityofsuch
learningisexcludedbyassumptionfromtheanalysis.

ArrowDebreusecurities.Ofcourse,neitheroftheseassumptionsarevalid,andtheymakesenseonlyin
thecontextofonemoreverystrongassumption:allindividualsareidentical.Therepresentativeagent
modelis,inthissense,morethanjustasimplifyingassumption.Witharepresentativeagentmodel,itis
conceivablethattheindividualcouldsolvetheinfinitelifetimemodelcouldunderstandthe
transversalityconditionsandfigureoutthedynamicpathconsistentwiththem.With,however,a
societywithheterogeneousagents,eachindividualwouldhavetosolveacomplicatedinfiniteperiod
generalequilibriumproblemknowingthepreferencesofallotherindividualsandtheproduction
technologyofallfirmsobviatingoneofthebasicpresumedadvantagesofcompetitivemarkets,the
abilitytofullydecentralizedecisionmaking(sofirmsonlyhavetoknowpricesandtheirowntechnology
toknowwhattodo).18
TheProblematicNatureoftheRepresentativeAgent
Buttherepresentativeagentmodel,asunrealisticasitis,bringswithitthreefurtherproblemswhich
makeitparticularlyunsuitableforanalysesofdeepdownturns.First,therecantbeanyinteresting
problemsofinformationasymmetries,thatis,unlessindividualssufferfromacuteschizophrenia;andit
ishardtoreconcilethatassumptionwiththepreviousassumptionoffullrationality.
Secondly,financialmarketsarelargelyirrelevant.Afterall,whoislendingtowhom?Andbythesame
token,thenatureofthefinancialinstrumentsisirrelevant.Thereisnoonewithwhomonecanshare
risk.Thereisnomatchingofriskswithriskpreferences.Thus,byconstruction,thesetheorieshave
littletosayaboutfinancialcrises.(Itispossible,ofcourse,tosolvethisconundrumbyassuminga
smallopeneconomy,borrowingfromabroad.)
Andthirdly,distributionisnotimportant;distributiveconsequencesofshocksandpoliciesdonot
matter.
Policyimplications
Themodelhasstrongpolicyimplications.Because,underthehighlystylizedassumptions,markets
respondefficientlytoexogenousshocks,therearenomarketfailures,andhencenorolefor
government.Thereisnounemployment:variationsinemploymentarejustvariationsintheamountof
timethatindividualsspendenjoyingleisure.Thereissomethingpatentlyunrealisticaboutthis
interpretationofunemployment:normallyindividualsseemhappywhentheyareenjoyingleisure;but
thereisampleevidence(bothfromsurveysandbehavioralsymptoms,suchassuicides)thatindividuals
arenothappyineconomicdownturns,andespeciallysoindeepdownturns.
TechnologyShocksandCollectiveAmnesia
Thesearebutafewofthelargenumberofunconvincingaspectsofthesemodels.Earlier,Inoted
others(e.g.theassumptionthattheshockstotheeconomyareexogenous,notendogenous).Inote
justonemore:Theshockstotheeconomythatthesefocusonaretechnology(orsupply)shocks.

18

Oneofthepeculiaraspectsofthesemodelsisthatiftheyweretruethenmarketsocialismwouldhaveworked.
(SeeStiglitz1994.)

Employmentdecreaseswhenlaborbecomeslessproductive.Ofcourse,whileitiseasytoexplain
positivetechnologyshocks(wediscoveranewwayofproducingsomething),itismuchmoredifficultto
explainnegativeshocks.Hastherebeenaboutofcollectiveamnesia,suchthatweforgotwhatwe
knew?Wasthereanepidemicofamnesiain1929andtheyearsfollowing,sofarundetectedinmedical
records?
Inspiteoftheimplausibilityofsuchnegativeshocks,suchmodelscontinuetobeusedtoexplain
economicdownturns.ThusKydlandandZarazaga(2002)purporttoexplainArgentinas2001crisisas
theconsequenceofanegativetechnologyshockwithinaRBCframeworkasiftherehadbeenan
epidemickillingoffalargefractionsoftheirengineers.
Thereisafurtherproblem:typically,thetimingisoff.Therewasnomajortechnologyshockcoinciding
withanyofthemajoreconomicdownturnsthatcouldexplainaperturbationofthemagnitude
observed.Ofcourse,inmodelswithforwardlookingagentswithrationalagents,asimportantasthe
shockitselfisthenewsoftheshock:whenagentslearnthattechnologyinthefutureisgoingtobe
differentfromwhattheyhadexpected.Butthisdoesnthelp;insomewaysitmakesexplaininglarge
perturbationsevenmoredifficult:therewasnomajornews,nosuddenchangeinexpectationsabout
futuretechnologysurroundingtheonsetofanyofthemajoreconomicdownturns.
Butthereisastillfurtherproblem:typically,ashiftinthesupplycurvetotheleftwouldleadtohigher
prices.(Theoilpriceshockhasthiseffect.)Butdeepdownturnsaremarkedbydeflation,notinflation.
Somethingelsemustbegoingon.
B. NewKeynesiantheorieswithrigidwages/prices(DSGEGenerationII)

ThesetheorieskeepmostoftheassumptionsoftheRealBusinessCyclemodels,andthusmostoftheir
flaws.Theyrepresenttheminimalchangeintheconventionalcompetitiveequilibriummodelrequired
togetsustainedunemployment.

Thus,liketherealbusinesscycletheories,theyassumethattheshockstotheeconomyareexogenous
(andstillmostlysupplysideshocks).Andtheycontinuetoassumerationalexpectations.Aswenoted
earlier,therewasnoexogenousevent,orevennewsaboutpreviouslyunanticipatedexogenousevents
thatwouldbeoccurringinthefuture,thatcouldexplainthesuddendecreaseineconomicoutputin
2008orthemarkedshiftintheeconomicequilibrium.
Nominalrigidities
Themaindifferencewithrealbusinesscyclesistheassumptionofrigidwagesandprices(andtypically,
itisnominal,notrealrigidities,thatareassumed).Theconsequence,ofcourse,isthatmarketsmaynot
clearinparticular,themarketforlabor,sothattherecanbepersistentunemployment.
Butanalyzingintertemporalmodelswithoutmarketclearingisverydifficult:insuchmodels,theshort
sideofthemarketdominates(thatis,ifdemandislessthansupply,equilibriumoutputisdeterminedby
demand).Theregimethattheeconomyisinateachdatecanaffecttheregimeitisinotherdates:they
9

canbealargemultiplicityofequilibria.Moreover,thereareimportantincomeeffects:anincreasein
aggregatedemandatanydatechangesbudgetconstraints,andhasincomeeffectsatotherdates,
possiblycausingachangeinregimeatthoselaterdates.Beginninginthe1960s,avarietyofversionsof
suchmodelswerestudiedbyGandmont,BarroandGrossman,andStiglitzandSolow,amongstmany
others.ButthesemodelswerenotwellsuitedtobeasimplegeneralizationoftheRBCmodels.
Thusthenewmodelstypicallyassumedenoughflexibilitythatmarketscleared.Thelaborsupplywas
assumedvariable,sotherewerevariationsintheemploymentrate,thoughnotintheunemployment
rate.19Thisbyitselfisamajorlimitationofthesemodelsinexplainingdeepdownturns:akeyissue,we
suggestedearlier,isthedepthanddurationofunemployment.
Themajorexplanationofnominalrigiditieswasmenucostsanamewhichperhapsappropriately
trivializedtheexplanationitself.Withmoderntechnology,reprintingthemenu,toreflectchangesin
prices,isalmostcostless.Morefundamentally,ashiftin,say,thedemand(orsupply)curvefora
perishableproductnecessitateseitherachangeinoutputorachangeinprices.Afirmneedstolookat
theseadjustmentscoststogether,notseparately.Typically,thecostsofadjustingpricesareanorderof
magnitudesmallerthanthoseassociatedwithadjustingquantities.Thus,forperishables,menucosts
simplycannotexplainpricerigidities.
Fornonperishables,mattersaredifferent,forthereisathirdalternative:goodscanbeputintoor
takenoutofinventories.Onethenhastocomparethosecostswiththecostsofadjustingpricesor
quantities.Butthisisaquitedifferentproblemthanthatposedinthemenucostliterature.Greenwald
andStiglitz(1989)havearguedthatcentraltotheanalysisisuncertainty,includinguncertaintyabout
howothermarketparticipantswillrespondtoachangeinpriceorquantity.Theyexplainhowsuch
uncertaintycanexplainnominalpricerigidities.
Anotherstrandofliteratureexplainingnominalrigiditiesfocusesoncontractrigidities,e.g.inmodels
withstaggeredcontracts.Contractsmayaffectinframarginaladjustments,butthereisnormallyample
scopeformarginaladjustments,andinstandardtheories(e.g.ignoringefficiencywageeffects,which
wediscussinthenextsubsection)thosemarginaladjustmentsshouldsufficetorestorefull
employment,oratleasttogreatlyreduceunemployment.20Inshort,contracttheoryonitsown
providesanincompletebasisforexplainingthenominalrigiditiesthatcouldgiverisetoasustainedhigh
levelofunemployment;butcontractingrigiditiescanplayanimportantroleinamoregeneraltheory.
Stillanothermarketimperfectioncommonlyintroduced(incombinationwiththeprevious)is
monopolisticcompetition,throughtheuseofDixitStiglitzpreferences.Thereisanartformin

19

Therearemodels,ofcourse,withcostlysearch,wheretherecanbefrictionalunemployment.Thislectureis
concernedwithdeepdownturns,wherethelevelofunemploymentgoeswellbeyondthatwhichcanbedescribed
bysearchfrictions.Asweexplainlater,thereareotherlabormarketfrictionswhicharerelevant.
20
Thosefirmsthatareintheprocessofsettingwagesandpricesdosoknowingthattheywillnotbeabletoadjust
themforacertainlengthoftime,andhencehavetotakeintoaccounteconomicconditionsinthosefuture
periods.Thus,iftheeconomyisadjustingtowardseliminatingunemploymentthroughloweringwagesandprices,
thisinducesthosefirmsabletoadjusttolowerthemmorethantheywouldiftheyweremaximizingprofitsonly
lookingatcurrentwagesandprices.

10

introducingdistortions;theyhavetobesimpleenoughtobetractable,plausible,andyetnotsosimple
thattherewouldbeasimplepolicybywhichgovernmentcouldundothedistortionandreturnthe
economytotheRBCideal.Becauseofthedistortions,ofcourse,themarketequilibriumisnotin
generalefficient,andsoinprinciplethereisaroleforgovernmentpolicy.
Buttheproblemindeepdownturnsisnotpricerigiditybutdeflation!
Thefocusonpricerigiditiesseemsstrangelyoutofkeepingwiththemajorpreoccupationindeep
downturnswithdeflation.Today,centralbankersinmanycountriesareworriedaboutdeflation.In
Japan,theobjectiveofinflationtargetingistoconvincethemarketthattherewillbeinflationinthe
futureandtobringanendtotheeraofdeflation,whichitisbelievedhascontributedtoJapans
weaknessoverthepasttwodecades.IntheGreatDepression,pricesfellat10%ayearitishardtocall
thatnominalrigidity.
InearlyversionsofNewKeynesianmodels,financialmarketswereassumedtoworkefficiently;inlater
versions,financialfrictionswereintroduced(see,e.g.BernankeandGertler(1990)),butthesenever
cametoplaythecentralrolethattheyplayedinthealternativestrandofNewKeynesianmodels
discussedinthenextsubsectionnotsurprisingly,becauseitishardtohaveaninterestingfinancial
marketinarepresentativeagentmodel;andamajorsourceoffinancialfrictionsareinformation
asymmetries,whichagaincantariseeasilywithinarepresentativeagentmodel.Ofcourse,aswenoted
inthecaseofRBCmodels,onecanintroducefinancialmarketsinasmallopeneconomymodel;but
eventhen,suchmodelshavetobecarefullycraftedtoavoiddistributionaleffects.Ifthereisanopen
economywithequitymarkets,thenchangeswithintheeconomycanredistributeincometoforeign
owners,withmacroeconomicconsequences.
Priceandwagerigidities,aswehavenoted,wereatthecenterofthemodel,sothatasaresultfinancial
marketsandfrictionswithinthosemarketswerelargelyasideshow,andnotelaboratedupon.There
werenot,forinstance,banks,andtherewasnotasaresultananalysisofhowmonetarypolicyaffects
banks,andthroughthebanksthesupplyofcredit.Additionalcomplicationswereintroducedas
Ptolemaicexercises,asitbecameincreasinglyevidentthatthesemodelsdidnotprovideagood
descriptionofwhatwasgoingon.Inparticular,financialmarketsandtheirimperfectionsdonot,inthis
strand,playthecentralrolethattheydothemodelstowhichwenowturn.
C.AlternativestrandsofNewKeynesian
EventhisbriefdescriptionofthetwodominantstrandsofmacroeconomicliteraturethatIhavejust
describedshouldmakeitclearthatthesemodelsdonotprovideasoundbasisforunderstandingdeep
downturns.Theyarenotconstructedtoprovideanswerstothethreecentralquestionsposedinthe
firstpartofthislecture;andtheydonotdothat.
Thereareseveralalternative(andinsomewayscomplementary)strandstoaliteraturewhichIshould,
forlackofabetterterm,refertoasfinancebasedNewKeynesianmodels.Muchofmydiscussionwill

11

focusontheFisherdebtdeflationmodel(revivedbyGreenwaldStiglitzin80s,early90s)21,butIwill
haveafewwordstosayabouttheimportantworkofMinsky(1992).
InotethattheDSGEmodelswithfixedmoneywagesandpricesseemtohavesuccessfullyappropriated
forthemselvesthetitleNewKeynesian.ThereisanaturalsenseinwhichHickspriceandwage
interpretationofKeyneswasextendedtothesemodels.ButHicksmodelledonlysomeaspectsof
KeynesGeneralTheory.Ibelievethatthemodelsdiscussedhere,wherewagesandpricesareflexible,
areasormoreconsistentwiththecentralinsightsoftheGeneralTheory,andthus,whiletheyhavelittle
todowiththeNewKeynesianmodelwithfixedwagesandprice,theyfullydeservetheepithetNew
Keynesian.
Financialfrictions
Inthiswork,thefinancialsectoriscentral:itisthesourceofrigiditiesthathelpexplainthe
amplificationandpersistenceofshocks,anditisthesourceoftheperturbationstotheeconomy.
Themodelsfocusonseveralfinancialmarketimperfections,severaldeviationsfromtheperfectmarkets
paradigm.Therecanbecreditandequityrationing.Firmsmaynotbeabletoborrow;theamountthey
canborrowmaybelimitedbytheircollateralortheirnetworth;theymaynotbeabletoraisenew
equityormoreprecisely,theremaybeahighcostfromthedilutionofexistingshareholdersfrom
doingso.Muchofthelendingintheeconomyismediatedbyinstitutions(banks),whichthemselves
facecreditandequityconstraints,aswellasregulatoryconstraints.
Moreover,financial(debt)contractsaretypicallynotindexedtoinflation(orotherrelevantshocks.)
Thatmeansthatwhenafirmexperiencesanegativeshocktoitsdemand,leadingtolowerprices,its
revenuesdecrease,butwhatitisobligatedtopayremainsunchanged.22Capitalmarketimperfections
explainwhyafirmcannoteasilyraiseadditionalequitytooffsetthereducedequityresultingfromthe
reducedrevenues.
Moreover,riskmarketsinsuringfirmsagainsttheimportantriskswhichtheyfacesimplydontexist.
Eachofthesemarketimperfections,inturn,canandhasbeenexplainedintermsofimperfect,costly,
andasymmetricinformation,transactionscosts,thecostsofverifyingstatesofnature,costsof
bankruptcy,andthedifficultiesandcostsofwritingandenforcingcontracts.23
Macroeconomicexternalitiesarepervasive

21

Seetheworkslistedinthereferences.TwoarticlesprovidingabroadsurveyofourperspectiveareGreenwald
andStiglitz(1988band1993b).SeealsoGreenwaldandStiglitz(2003a).
22
Asweexplainbelow,thisargumentevenappliestodisinflationlowerratesofwageandpriceinflationthan
wereanticipated.Forthen,thefirmsbalancesheetwillbeweakerthanitwasanticipatedtobe.
23
Oncreditrationingwithandwithoutendogenouscollateralconstraints,see,forinstance,StiglitzandWeiss
(1981,1983,1986);onequityrationing,seeGreenwald,Stiglitz,andWeiss,1984andMaljufandMyers,1984;on
otherimplicationsofimperfectinformationforfinance,seeStiglitz,1982;oncostlystateverification,see
Townsend,1979;ontheroleofbankruptcy,see,e.g.Stiglitz(1969,1972),Hellwig,1977,andGreenwaldand
Stiglitz(2003);andondebtenforcement,seeEatonandGersovitz1981andEaton1986.

12

Wheneverthereisanincompletesetofriskmarketsandimperfections/asymmetriesofinformation
thatisalwaysmarketsarenot(constrained)Paretoefficient.(GreenwaldandStiglitz,1986.)Aswe
explain,pecuniaryexternalitiesmatter.Systematicmicroeconomicexternalitiesadduptomacro
economicexternalities.Thesearepervasive:AsKorinek(2011)andJeaneandKorinek(2010)pointout,
therecanbe,forinstance,toomuchindebtednessortoomuchborrowingfromabroad.

Balancesheetsmatter
Inthestandardneoclassicaltheory(whichunderliesbothRealBusinessCycleTheoryandtheNew
Keynesianrigidwageandpricemodels),balancesheetsdontmatter;neitherdoesafirmscashflow.
Investmentsarebasedonexpectationsiftheexpectedpresentdiscountedvalueoftheprofits
associatedwithaprojectisgreaterthanthecost,theprojectwillbeundertaken.Thereareperfect
capitalmarketsthereisnocreditrationingandperfectriskmarkets.Bankruptcyissimplynota
matterofconcern.
Butiffirmscannotinsurethemselvesagainstrisksthatmatter(forinstance,thatthepriceoftheir
productwillfall)andtheycannot(easily)raisenewequity,thentheywillactinariskaversemanner,
andthisaffectseveryaspectoftheirbehavior.24Inparticular,asafirmexpands,itmustborrowmore;
andthatmeansthatifthefirmexpands,thereisahigherprobabilityofbankruptcy.Now,partofthe
marginalcostofproducingmoreisthemarginalbankruptcycost.Sotoo,ifthebalancesheetofthefirm
shrinks,itmustborrowmoretoproducethesameamountthatitotherwisewouldhaveproduced;but,
thatmeansthebankruptcyprobabilityishigher.
Hence,ashrinkageofthefirmsbalancesheetmeansthatfirmswillnotwishtoproduceasmuch,
employasmanyworkers,orengageinasmuchinvestment.(GreenwaldandStiglitz,1993a.)Thereare
effectsbothondemandandsupply.
Redistributionsmatter
Acorollaryofthesecapitalmarketimperfectionsisthatredistributionshaverealeffectsandthis
wouldbetrueevenifallindividualshavethesamepreferences,butisevenmoreso,giventhatthey
dont.Changesinpricesthatonthefaceofitmightlooksimplyredistributivehaverealaggregative
effects.Inaclosedeconomy,forinstance,theincreaseinthepriceofoilimprovesthebalancesheetof
oilproducersandhurtsthoseofusers,andthesetwoeffectsmightappeartocancelandtheydointhe
standardperfectmarketsmodels.Butiftherearecapitalmarketimperfections,thenthechangesin,
say,demandforinvestmentandemploymentbythosewhogainmaybefarlessthanthereductionson
thepartofthosewholose.

24

Firmsmayactinariskaversemannerforotherreasons:managerslongtermcompensationdependsonhow
wellthefirmthattheyaremanagingdoes;theycannotfullydiversifyoutofthisrisk.SeeGreenwaldandStiglitz
(1990a)andStiglitz(1982).

13

Bythesametoken,onemighthavethoughtthatnotindexingdebtcontractshasonlyadistributive
impact:thelendersgain(inthefaceofanegativeshock)andtheborrowerslose,andtheseeffectstoo
wouldjustcancel.Buttheydonot.
Banksasfirms
Inthesemodels(unlikethetwootherstrandsjustdiscussed)thefinancialsectorisimportant,and
financialinstitutionsbanksinparticularmatter.Banksarespecializedinstitutionsthatgatherand
processinformationaboutborrowerscreditworthinessandmonitordebtorstomakesurethatthey
canpaybackwhatisowed.Thereisasystemofaccountability,farbetterthanwiththeshadow
banking/securitizationmodel:ifabankmakesaloananditturnsbad,thebankbearstheconsequence.
Hencethebankhasstrongincentivestodoagoodjobonduediligence.
Banksborrowmoney(acceptdeposits)and,afterascertainingthecreditworthinessofdifferent
potentialborrowers,lenditout.Themoretheylend,themoretheyhavetoborrow,andthisincreases
theprobabilitythattheygobankrupt(unlesstheyweretoincreasetheircapitalizationproportionately).
Thetheoryoftheriskaversefirmdescribedinpreviousparagraphsappliesjustaswelltothetheoryof
theriskaversebank.
Accordingly,changesinbankbalancesheetshavefirstordereffects.Changesinbankbalancesheets
affecttheabilityandwillingnesstolend.Thisaffectscreditavailabilityandthetermsatwhichcreditis
available.AsStiglitzandWeiss(1981)pointedout,creditrationingisnotaphantasm.Indeed,everyone
inthefinancialcrisistalkedaboutaliquiditycrisisfirmsandbankscouldntgetaccesstocreditatany
interestrate.Remarkably,inthis,theonsetofthedeepdownturnthatwastobecometheGreat
Recession,eventhosewhohadseeminglybelievedinperfectmarketswerewillingtotalkaboutthelack
ofcreditavailabilitysomethingthatwasfundamentallyinconsistentwiththestandardparadigm.The
evidenceofcreditrationingwasoverwhelming.
Whydeflationordisinflationaproblem
TheFisher/Greenwald/Stiglitztheoryexplainswhydeflationcanbeasourceofproblems.Therealvalue
ofwhatfirmsoweandhavetopayontheirdebtsincreases.Thisdiminishestheirnetworthfromwhat
itotherwisewouldhavebeen.Ineffect,deflationincreasesafirmsleverage.Andthetheoryexplains
whyleveragematters.Atthesametime,aswehavenoted,thegainstothecreditorsdonotoffsetthe
lossestothedebtors.Intherepresentativeagentmodelwithoutfinancialfrictions,theincreasein
leveragewouldnotmatter.
Itshouldbenotedthatthisargumentevenappliestodisinflationlowerratesofwageandprice
inflationthanwereanticipatedmeanthatthebalancesheetisweakerthananticipatedand,therefore,
thatoutput,employment,andthedemandforinvestmentgoodsarealllower.
Whytheabsenceofindexingmatters
Thisdiscussionshouldhavemadeclearwhytheabsenceofindexingofdebtcontractsmatterssomuch.
Theabsenceofindexinginitselfcanleadtoloweremploymentandinvestment,inthefaceof
14

bankruptcycosts;andthiscanhelpexplaintheamplificationofshocksaswellaspersistence.Foras
firmsborrowmore,theprobabilityofbankruptcyincreases,andtheytakethatintoaccountinmaking
productionandinvestmentdecisions.Anadverseshockwhichlowersnetworthinduces,aswehave
noted,lessinvestmentandproductiononthepartofeachfirmandwhensuchindividualdecisionsare
aggregatedthroughouttheeconomicsystem,theyleadtooverallloweroutputandemployment.A
smallshocktonetworthcanhaveamacroeconomiceffectwhichisamultipleoftheoriginalshock.
Andbecausebalancesheetscannotberestoredinstantaneously(indeed,ittypicallytakesa
considerableperiodoftime,especiallyasproductionisscaledback),andbecausefirmswillbereluctant
toraisenewequity(eveniftheycan),theeffectsofashockmaylastalongtime.
Balancesheetrecessions
Thus,theGreenwaldStiglitz(1993a)modelprovidesanexplanationofbalancesheetrecessions.(Many
havesuggestedthatthe2008recessionisabalancesheetrecession.25)Therearethreecriticalaspects
ofabalancesheetrecession:(a)Ashockwhichleadstoanunanticipatedworseningofthebalance
sheetsofmanyfirmsintheeconomy.(b)Theresponsetotheworseningofthebalancesheet:a
contractionineconomicactivity;and(c)Aslowhealingofbalancesheetnecessaryandsufficientfor
therestorationoftheeconomytofullemployment.
Theshockcanbeapricelevelshock(contractionarymonetarypolicyleadstooveralllowerprices,
meaningthattherealvalueofwhatthefirmoweshasincreased);ademandshocktoaparticular
categoryofgoods(individualsshiftaway,atleasttemporarily,frombuyinglargecars);orasupplyshock
(thepriceofoilincreases.)
GreenwaldandStiglitzthendescribetheresponsetotheworseningofthebalancesheet.Thereare
bothdemandandsupplysideeffects.Firmswillnotwishtoproduceasmuch,employasmanyworkers,
orengageinasmuchinvestment.Aswehavenoted,allofthisisquitedifferentfromthestandard
neoclassicalworld,wherethereareneitherthedemandnorthesupplysideeffects;andthedifference
isevengreaterwiththerepresentativeagentmodels,wheretherearentanyredistributiveeffects.
Here,arelativepriceshockwhichstrengthsthebalancesheetofsomefirmandweakensthatofanother
byexactlythesameamountstillhasrealeffectsontheaggregateequilibrium.
Centraltothenotionofabalancesheetrecessionistheideathattheadverseimpactsonthebalance
sheetcannotbeundoneovernightsimplybyraisingmoreequity.Theequityinthefirmhastobe
rebuilt,throughretainedearnings,andthisisaslowprocess.Andthatisakeyreasonforthe
persistenceofdownturns.
But,asIdiscussbelow,trulydeepdownturnsaremorethanbalancesheetrecessions:theycanpersist
evenafterbalancesheetsarelargelyrestored.

Riskperceptionsandconfidence

25

See,inparticular,Koo(2011).

15

Inthestandardmodel,confidenceandtheextentofuncertaintymatterslittle:becauseriskis
diversifiedthroughouttheeconomy(throughperfectinsurancemarkets),whatmattersisthemean
return.ButintheseNewKeynesianmodels,riskmattersagreatdeal.Ameanpreservingincreasein
riskincreasestheprobabilityofbankruptcy,leadingtoresultssimilartothosethatarisefromabalance
sheetshock.
Thisprovidesanotherchannelthroughwhichamplificationandpersistenceoccurs:aftertheinitial
adverseshock,unlessactivegovernmentpoliciespreventadeepdownturn,uncertaintiesincrease.No
firmcanbesurewhetheritscustomersorsupplierswillsurvive.Abankruptcyofanyofitstrading
partnersposestheriskofanothernegativebalancesheetshock.
Indeed,inaninterlinkedeconomy,theprobabilityofthebankruptcyofonefirmleadstoanincrease
probabilityofthebankruptcyofitstradingpartners,butthisleadstoanincreasedprobabilityofthe
bankruptcyofthosefirmstradingpartners.Thedisruptionemanatesthroughtheeconomicsystem.
(Withthebankruptcyofonefirmdependingonfirmswithwhichitisinterconnected,wehaveacomplex
generalequilibriumsystem,which,withbankruptcycosts,hasonlybeensolvedrecently.(Roukny,
Battiston,andStiglitz,2015).26)
SystemicBankruptcy
Bankruptcyitselfhasrealsocietalcosts.Muchoftheinformationinoursocietyisembeddedwithin
corporations.Thebankruptcyofanenterpriseleadstothelossoforganizationalandinformational
capitalanegativeshocktotheeconomy,witheffectssimilartothoseassociatedwiththenegative
productivityshocksassumedinrealbusinesscycletheory,butwhicharefarmoreplausible.Andof
course,themagnitudeoftheseandtheirconsequencesdependsontheorganizationalstructureofthe
economyandoneconomicpolicies.
Hysteresiseffectsandpersistence
Theserealconsequencesofbankruptcyarealsopartoftheexplanationofpersistence,partofthe
reasonthattherearesignificanthysteresiseffects.
WhenIwaschiefeconomistoftheWorldBank,duringtheEastAsiacrisis,wehadmanydisputeswith
theIMF.AsthecrisisfirstbrokeoutinThailandinJuly1997,theIMFwantedtorespondwithitsusual
recipe,jackingupinterestrates,intendedtopreventthecollapseofthecurrency.Wewereworried
thatwithevidencethattheThaieconomyalreadyweakening,theincreaseintheinterestratewould
exacerbatetheeconomicdownturn;andwefearedthatthehopedforpositiveeffectswouldnotbe
felttheincreaseduncertaintyabouttheweakeningeconomytowhichthehigherinterestratewould
contributecouldevenexacerbatecapitaloutflows,worseningthefalloftheThaiBaht.Wewereafraid
toothatthehigherinterestrateswouldleadtothebankruptcyofalargenumberoffirms.TheIMFs
responsewasthatweshouldntworry:ifouranalysiswascorrect(andevidencethatthatwasthecase
mounted),theywouldreconsidertheirposition,reversingcourseandloweringtheinterestrate.ButI

26

Earlier,EisenbergandNoe(2001)providedasolutionwithoutbankruptcy.

16

arguedthatthereareimportanthysteresiseffects:thefirmsthatareforcedintobankruptcyatthehigh
interestratesdonotsuddenlybecomeunbankruptwheninterestratesarelowered.ThoughtheIMF
prevailedatthemomentimposingtheirusualcombinationofhighinterestratesandausterity,our
analysisprovedtotallycorrect:thepoliciesbroughtonadeeprecession,withalargefractionofthe
loansbecomingnonperformingandalargefractionoffirmsnotbeingabletopaywhatwasowed.
Justasittakestimetorestorefirmandbankbalancesheets,itisevenhardertocreatenewfirms,to
replacethefirmsthathavebeenlost.Thereareanalogouseffectsonhumancapital:thosewhose
educationisinterruptedbyadownturntypicallydonotresumetheireducationwhengrowthresumes;
thelossinhumancapitalassociatedwiththeonthejoblearningthatdidnotoccursimplybecauselarge
numberswerenotonthejobisneverrecouped.27
SMELending
Thesemodelsalsohelpusunderstandbettersomeofthedetailsofthecurrentandsimilardownturns.
First,investmentandemploymentinsmallandmediumsizedenterpriseswasparticularlyhardhit,both
intheUnitedStatesandEurope.SMEsareparticularlydependentonbankinginformation
imperfectionsprecludeaccesstocapitalmarketsformostSMEs.SMElendinginturnislinkedto
regionalbanks,notasurprisegiventheimportanceoflocalinformation.28Thus,itmadeadifferenceto
aggregatelendingwheremoneywaspumpedintothesystemwhetherthebigbankshadtheirbalance
sheetsrestored,orthesmallerandregionalbankswerehelped.(Inthe2008bailouts,neitherthe
AdministrationnortheFedgraspedthis.Theyworriedaboutsystemicallysignificantbanks.But
collectively,thesmallerbanksaresystemicallysignificant.Toolittlemoneywenttohelpthecommunity
andregionalbanks,partofthereasonthatSMElendingremaineddepressedforsolong.)
Ofcourse,tounderstandhowpolicieswillaffectlending,especiallytosmallandmediumsized
enterprises,atheoryofbankingisrequired.29Thelinkbetweenwhatmonetaryauthoritiesdowiththe
changesinthelendingbehaviorofbankshastobeunderstood.Itisremarkablethatmostcentralbanks
usedmodelswithnobanks:underthesemodels,iftheywerecorrect,centralbanksmightnoteven
havecomeintoexistence.
Securitization
Butwhilethestandardmodelsdidntexplainlendingbybankswell,neitherdidtheydoagoodjob
explainingwhathappenedtononbanklending,thevastsecuritizationmarketthatwasatthecenterof
thecrisis.Theysimplyassumedthatmarketsworkedwell,thatriskshadbeendiversified,andthese
improvementsinriskmanagementweregivenmuchofthecreditforthegreatmoderation.Infact,
marketswerenotworkingwell,anddiversificationmayhavemademattersworse,ratherthanbetter.

27

Thisispartofthemissingcapitalthathelpsexplainwhy,afteracrisis,GDPremainswellbelowtheprecrisis
trendline.SeeStiglitz(2015c).
28
GreenwaldandStiglitz(2003)emphasizedthis.
29
Thepurposeofour2003bookwastoprovidesuchatheory.

17

Therewere,infact,fundamentalflawsinthemodelofsecuritization(whichhelpsexplainwhytheUS
governmentstillhasacentralroleintheAmericanmortgagemarket,underwritingmorethan90%of
mortgages,morethaneightyearsafterthebreakingofthehousingbubble.)Informationisapublic
good,and,asSandyGrossmanandIlongagopointedout(GrossmanStiglitz,1976,1980),iffinancial
marketswereinformationallyefficientinthesensethatinformationwasefficientlyconveyedthrough
prices,therewouldbenoincentivetogatherinformation.Marketsmustnecessarilybeinformationally
inefficient.Somethoughtonecouldsolvethisproblemwithcreditratingagencies.ButtheCRAwere
paidbythosethattheywererating:therewasaracetothebottom.Theirperformancewasdismal.
Thereis,infact,noeasysolutionthereisnoviableprivatealternative.Bankingprovidesananswer
thosewhomakealoanbeartheconsequencesofanymistakes.30
Thestructureofcreditnetworksandoptimaldiversification
Beforethecrisis,thestandardmodelspaidnoattentiontowhathappenedwithinthefinancialsector.
Theseweredetailsofnomoment,orsotheyargued.Onecoulddescribethefinancialsectorbya
representativefirm,justasonecoulddescribethehouseholdsectorbyarepresentativehousehold.
But,ofcourse,whathappensinsidethefinancialsectormattersagreatdeal.Financialinterlinkages
financialnetworks,andtheirstructurematter.Acollapseofonefirm(LehmanBrothers)mighthave
ledtothecollapseoftheentirefinancialsector,hadtheFederalgovernmentnotintervened.
Thereweretwocriticalanalyticmistakes.Thefirstisrelatedtothemacroeconomicexternalities
discussedearlier:ifthereareexternalitiesexertedbyonefinancialagentonotherswhichtheydont
takeintoaccount,thenthebehaviorofthefinancialsectorcannotbedescribedwellbyamodelwitha
single(rational)financialfirm.
Thesecondisrelatedtothehypothesisthatdiversificationunambiguouslyimprovesmatters.Thatis
thecaseinmodelswhereallrelevantfunctionsareconvex.Butnonconvexitiesarepervasive:there
are,forinstance,bankruptcycosts.Moreover,afirmwhichfacesanegativeshockmayfinditselfpaying
higherinterestratesleadingtoaprocessoftrendreinforcement.Insuchasituation,diversification
maymakemattersworse.(Noonewouldsuggestthattheresponsetoacontagiousdiseaseis
diversificationspreadingthosewhohavebeenexposedtothediseasearoundtheworld;butthat,in
effect,waswhatdiversificationimplied.)
Ironically,theadvocatesofglobalizationandfinancialintegrationarguedforthevirtuesof
diversificationbeforecrises;butafterwards,theyshiftedtheirattentiontowardscontagion
emphasizingineffecthowinterlinkagescouldleadtothespreadofaprobleminonecountrytoothers.

30

Financialmarketsthoughtthattheyhadfoundagoodsolutiontothemoralhazardproblemthatariseswhenthe
partiesoriginatingmortgagesandpackagingthemdifferfromthosewhoultimatelyholdtheassets:the
originatorsandtheinvestmentbanksthatputtogetherthesecuritizationpackagesmadewarrantiesand
representationsconcerningthemortgages;anymortgagethatwasnotasrepresentedcouldbeputbacktothe
originatorand/orinvestmentbank.Intheaftermathofthecrisis,itbecameevidentthattherewaswidespread
fraud,andtheoriginatorsandinvestmentbanksrefusedtohonorthecontract.Insomecases,aftervery
expensivelitigation,theywereforcedtodosobytheCourts.Thesecriticalaspectsofmarketsarenotembraced
bythestandardmodels.

18

Intellectualconsistencyshouldhaveforcedthemtotakeintoaccounttheserisksexante,beforethe
crisis.Infact,onecanshowthatthereisanoptimaldegreeofinterlinkage(diversification);andthat
afteracrisis,itmaybedesirabletoseverlinkagesimposingcapitalcontrols.31
Financialsectorimperfectionsandthecreationofvolatility
Financialmarketimperfectionsareimportantnotonlybecausetheyhelpexplainamplificationand
persistence.Theyarealsoanimportantpartoftheexplanationofthesourceofthedisturbance:the
breakingofthehousingbubbleandtheconsumerspendingbubbletowhichithadgivenrise.
Kindleberger(1978)andMinsky(1992)bothstressedtheroleofbubblesasasourceofeconomic
fluctuations.Whilethereissomeresearchsuggestingthatbubblescanexisteveninthepresenceof
rationalexpectations32,acloserlookatthisbubble,aswellasearlierbubbles,suggeststhatirrational
expectationsaswellasmassivefraud33playedacentralrole.Itseemsamisuseofintellectualresources
todwelltoolongonthecounterfactual:couldtherehavebeenacrisisifallindividualshadacted
rationallyandhadrationalexpectations.
Butasmodernbehavioraleconomicshasemphasized,evenifindividualsarenotfullyrational,their
behaviorcanbepredictable.34Thus,Minskyemphasizedthatasmarketsbecamebetteratmanaging
risk,individualsandfirmsmightundertakemorerisk,sothatthestabilityofthesystemmightnot
improvemuch.35Iftheybecameoverconfidentintheirabilitytomanagerisk(asseemedtobethecase
withsomeofourpolicyandfinancialleaders),thenthesystemmightbecomeevenmoreunstable.
Thus,wecanandshouldstudynotjusthowmarketsmightbehaveifeveryonehadrationalexpectations
andcommonknowledge,buthowtheyactuallydobehaveandhowpolicies(regulations)canaffect
thatbehavior.Itmightnothavebeenrationalforinvestors,seeingreturnsonsafeassetsfallwithloose
monetarypolicies,tograbforyield.(Standardtheorywouldhavepredictedthatthelowerreturns
wouldhaveledtomore,notless,riskaversebehavior.)Butifinvestorssystematicallydoso,thenwe
needtodesigncountervailingpolicies.
Bythesametoken,itmightnothavemadesenseformarketstoshiftsomuchriskassociatedwith
variationsininterestratestohomeowners36,butgiventhesefailingsinmortgagemarkets,itmakes
senseforgovernmenttoimposeregulationstopreventtheadversemacroeconomicconsequences.

31

ForearlydiscussionsofbankruptcycascadeshowthefailureofonefirmcanleadtothatofothersseeAllen
andGale,2000andGreenwaldandStiglitz,2003.Onoptimaldiversification,trendreinforcement,thedesignof
creditnetworks,andthepotentialdesirabilityofcreditcontrols,seeStiglitz(2010a,2010b)andBattistonetal
2007,2012a,2012b,2013;Gallegatietal2008;Haldane(2009)andHaldaneandMay(2010).
32
Thisincludesworkonsunspotequilibrium.
33
Seetheearlierdiscussioninthecontextofsecuritization.Inasense,itishardtoreconcilefraudwithrational
expectations:iftherewereevenasmallexpectationofsuchfraud,individualsandfirmswouldnothaveentered
intothecontracts.SeeGreenwaldandStiglitz(1992).Kindleberger(1978)notesthatsimilarproblemsoccurredin
manyoftheotherbubbles.
34
See,forinstance,Ariely(2010).
35
SeealsoGreenwald,Stiglitz,andWeiss(1984).
36
EvenGreenspandidnotseemtounderstandthebasicprinciplesoftheallocationofrisk.SeeStiglitz(2010).

19

Whetherrationalornot,therearelargemacroeconomicconsequencestothesebehaviors,andthus,
thereisaneedforgovernmentregulation.
Goingforward,Ibelieveanimportantpartoftheresearchagendashouldbetryingtounderstandbetter
thewayoureconomicsystemcreatesvolatility.Understandingthecreationandbreakingofcreditand
assetbubblesispartofthestoryapartinwhichwealreadyhaveagoodsenseofhowderegulation
andloosemonetarypolicycanfacilitatethecreationofsuchbubbles.Butthereismore:Earlier,I
describedongoingresearchonfluctuationsinaggregateexpectationsoffuturewealththeprocessof
pseudowealthcreationanddestruction,whichcangiverisetofluctuationsinaggregatedemand.
Creatingnewopportunitiesforgambling(tradingonthebasisofdifferencesinprobabilityjudgments)
whiledefendedonthegroundsthatdoingsowascompletingmarkets,makingtheeconomycloserto
theArrowDebreuidealactuallycanincreasevolatility.(GuzmanandStiglitz,2014,2015a,b.)
Beforeturningtothecontrastingpolicypositionsofthesevariousstrandsofmacroeconomics,Iwantto
addressthreeothercriticaldifferencesbetweenthislineofwork,andthetwodescribedearlier.
Disequilibratingdynamics
Thereisanotherreasonsuggestedbythesetheoriesforthepersistenceofdownturns:Shortrun
adjustmentsmaybedisequilibrating.Loweringrealwageswhichtypicallyisthedecentralized
marketsresponsetounemploymentandisnormallythoughttoberequiredifthegapbetweenthe
demandandsupplyoflaboristobereducedlowersrealaggregatedemand,exacerbatingproblemsof
unemployment.
Butthereareotherreasonsthatevenaloweringofnominalwagesandpricesmayexacerbatethe
economicdownturn,linkedtothefinancialmarketfailuresalreadynoted:Loweringnominalwagesand
pricesincreasesleverageofhouseholdsandfirms,loweringaggregatedemand.
Theincreasedleveragecan,inturn,increasebankruptcyprobabilities,leadingtothedestructionof
informationandorganizationalcapital,andincreasinguncertainty,withbothsupplyanddemandside
effects.This,inturn,leadstoweakerbanks,decreasinglendingandincreasinginterestrateschargedby
banks(increasingthespreadbetweentheTbillrateandthelendingrate.)
Realrigiditiesmatter
Inrealbusinesscycletheory,therearenorigidities,sothatmarketsalwaysclear.Bycontrast,wehave
arguedthatespeciallyinthecontextofdeepdownturns,itisobviousthatneitherthelabornorcapital
marketsclear:thereisbothunemploymentandcreditrationing(liquidityconstraintsbind).Inthe
NewKeynesiananalysis,attentioniscenteredaroundnominalrigidities.Inourearlierdiscussion,we
explainedwhysomeofthetraditionalexplanationsofthesenominalrigiditiesarenotconvincing.But
moreimportantly,itisrealrigiditiesthatpreventmarketsfromclearing.Eveniftherewerenominal
wagerigidities,ifpriceswereflexible,realwagescouldadjusttoclearmarkets.

20

Imperfectionsofinformationcangiverisetorealrigidities,bothinlaborandcapitalmarkets.37
Realrigiditiesanddecentralizedadjustmentprocesses
Slowprocessesofadjustment38toocanleadeffectivelytorealrigidities.Inadecentralizedeconomy,
wagesfallinresponsetounemployment(duetolackofclearinginthelabormarket),andthenpricesfall
inresponsetothegapbetweenaggregatedemandandsupply(duetolackofclearingintheproduct
market).Thenneteffectisthatrealwageschangelittle.(SolowandStiglitz,1968.)39
Labormarketfrictions
Thereisonemoreimportantsourceofrealrigidityintheeconomyoneaboutwhichthestandard
excessivelyaggregatedmacromodelscanhavelittletosay:individualscanbetrappedinonesector,
unabletomakeatransitiontoahigherwagejobelsewhere,eitherbecausetheycannotaffordtoobtain
therequisiteskillorbecausetheycannotaffordthemovingcosts.Capitalmarketsareimperfect,and
thoseneedingtomoveareofteninapoorpositioneithertoaffordtheseexpendituresontheirownor
toborrow.Insomecases,thesectorsoutofwhichindividualsneedtotransitionare,inasense,
successful:productivityhasincreasedsomuchthatthedemandforlaborhasdecreased.Thatwasthe
caseinagricultureinthefirstpartofthetwentiethcentury,andisthecaseinmanufacturingtoday.
Marketsontheirowndonotmanagesuchstructuraltransformationswell.40
Isthecurrentrecessionmorethanabalancesheetrecession?
Insomeways,weareinasimilarsituationtoday.Theenormousincreaseinproductivityin
manufacturingbeyondtheincreaseindemandmeansthatglobalemploymentwillbegoingdown;
andchangingcomparativeadvantagemeansthatanincreasingfractionofthatemploymentwillbein
developingcountriesandemergingmarkets.IntheUnitedStatesandEurope,thereneedstobea
structuraltransformationfrommanufacturingtotheservicesector,andagain,marketsdonotmanage
suchtransformationssmoothlyontheirown.Makingmattersworseisthefactthattwooftheservice
sectorsintowhichresourceswillbemoving,educationandhealth,aresectorswheregovernment,
understandably,playsabigrole.Butwithcutbacksingovernmentspending,thepublicsectorwillnot
beabletoplaytherolethatitshouldinmovingtheeconomyfromamanufacturingtoaservicesector
economy.
ThatiswhyIbelievethatthecurrentdownturnismorethanabalancesheetrecession.Evenwhen
balancesheetsarerestoredsaytoprecrisislevels,theeconomywillnotbebacktohealth:the
economywasnotinfacthealthin2007and2008beforethecrisis.Whatsustainedtheeconomythen

37

Thereisalargeliteratureonefficiencywages,datingbacktoStiglitz(1974)andShapiroandStiglitz(1984).
Explainedinpartbyuncertaintyandriskaversion(GreenwaldandStiglitz,1989).
39
Moreover,differencesintheprocessesgoverningpriceadjustmentsindifferentsectorsinadecentralized
economycangiverisetosignificantallocativedistortions.SeeStiglitz(1999).
40
Moregenerally,fixedandespeciallysunkcostsofhiringworkersalsocangiverisetorealrigiditiesinlabor
markets,leadingtounemployment.SeeGreenwaldandStiglitz(1987b,1995).
38

21

wasanunsustainablebubble.Intheabsenceofthebubble,aggregatedemandwouldhavebeen
insufficienttomaintaintheeconomyatfullemployment.
RationalExpectations
Wenotedthecentralrolethatrationalindividualswithrationalexpectationsplayedinthefirsttwo
strandsofeconomicresearch.Ibelievethatrationalexpectationsprovidesapoorguideto
understandingmacrobehavior.
Therearesomecontextsinwhichrationalexpectationsmightmakesense:astaticsociety,inwhichthe
onlysourceofvariabilityisweather.Insuchaworld,individualsmighteventuallylearnthefull
consequencesofeachpossibleobservablestateofnature(thoughgiventhenumberofsuchstates,itis
plausiblethattheywouldinfactusesimplerheuristics),andbasetheirbehaviorrationallyonsuch
expectations.
Buttoday,eveninthissimplisticcontext,rationalexpectationswouldmakenosense:climatechange
meansthatweareexperiencingweatherpatternsnotseenforperhapsmillionsofyears,andnotonly
arememorieslimited,butmanwasnotevenaroundthelasttimeweatherwassimilar.
Theworldisalwayschanging,sothatitisnotevenclearwhatisentailedbyrationalexpectations.The
structureoftheeconomytodayismarkedlydifferentfromwhatiswasnotthatlongago,andeconomic
policiesthatarebeingtriedtodayaredifferentfromthosethatwereeventriedinthepast.Howcoulda
rationalexpectationsmodelmakesenseinsuchasituation?
Inparticular,therehasntbeenadownturnasdeepasthisonefor80years.Theworld80yearsagowas
markedlydifferentwithdifferentpolitics,differentbeliefsabouttheeconomy,adifferenteconomic
andfinancialstructure.
Inrationalexpectationsmodels,everyonehassamebeliefs.Butaswehaveargued,divergencesin
beliefsareoffirstorderimportanceforunderstandingmarketsandmacroeconomicbehavior.Thishelps
explainthelargediversityofinterpretationsofeventsandpolicies.Evennow,therearedisagreements
aboutmagnitudesofmultipliers.Someofthesedisagreementsarebecausesomeeconomistsare
workingwiththewrongmodel.Itshouldbeobviousthatanymodelthatassumesthatlaborandcapital
marketsclearisnotgoingtoprovideinsightsintoadeepdownturn.Inferencesbasedonmodels
estimatedinnormaltimesareoflittlerelevanceindeepdownturns.Innormaltimes,theeconomyis
closetofullemployment,sothatanexpansionofgovernmentspendingcrowdsoutprivatespending.
Butthisisnotsowhentherearelargeamountsofunderutilizedresources,asinadeepdownturn.

InREmodels,thereisnolearning,noproblemofassessingwhetherweareexperiencinganextreme
outcomeinanoldregime,orwhetherwehavemovedintoanewregime.Butsuchlearningis,Ibelieve,
centraltobehaviorofeconomicagents.(Guzman,2013.)

22

Manycriticalaspectsofwhatwentonintheeconomyintherunuptocrisiscannotbereconciledwith
rationalexpectationsbehavioronthepartoflargefractionofeconomicactorsalthoughtherewere
oftenafewwhomadesomemoneybyexploitingseemingirrationalityonthepartofothers.Butthese
didnotsufficetopreventthecreationofamajorbubble.41(Thus,theargumentthattheeconomyacts
asifeveryonewererationalbecausethosethatarecanarbitrageoutanyinefficienciescreatedby
thosewhoarenot,waspatentlywrong.)
Thisismorethanjustastatementthatthecrisiswasnotexpected.42AsInotedearlier,thedesignof
mortgagesdidnotrepresentarationalandefficientsystemofrisksharing.43Moreover,thedominant
marketethosseemedpredicatedonthebeliefthathousingpricescouldincrease,seeminglyforever,
unabated.Butitshouldhavebeenobviousthatitwasvirtuallyinconceivablethathousingprices/real
estatepricescouldcontinuetogrow:therewerelimitsonspendingonhousing(especiallygiventhe
stagnationinincomesofsomanyAmericans)andthereisavirtuallyunlimitedsupplyoflandinNevada
desert,limitingtheextenttowhichlandpricestherecouldhaveincreased.Itwasthusremarkablethat
somanyofoureconomicleaders,includingthechairoftheFederalReserve,seemedunconcernedthat
theremightbeabubble.
D. ContrastingElements
Whilethethreestrandsofmacroeconomicsthatwehavedescribedsharemuchincommon,Ihopethat
theabovediscussionhashighlightedsomeoftheimportantdistinctions.Thereareseveralinparticular
towhichIwishtodrawattention,andwhichwillplayanimportantroleinthepolicydiscussionto
follow.
Deepdownturnsareamanifestationofdeepandpervasivemarketfailuresdeviationsfromthe
standardcompetitiveequilibriummodelwhichunderliesrealbusinesscycletheory.Marketsfailin
manyways,andthestrandofNewKeynesianmodelemphasizingnominalwageandpricerigidity
probablyhasidentifiedonesuchmarketfailure,butperhapsnotthemostimportantone.Ihave
suggestedthatthealternativestrandofNewKeynesianmodelsemphasizingfinancialsector
imperfectionsmaybemorerelevant,atleastfordeepdownturns.Indeed,thethirdstrandemphasizes
thatthecentralproblemconfrontingeconomiesfacingdeepslumpsmaynotbepricerigidities,butprice
flexibilities.Thecurrentworriesaboutdeflationarejustified.Economiesinwhichwagesandpricesare
lessflexibleperformbetter.

41

Moregenerally,itcanbeshownthatitiseasytohavebubblesconsistentwithshortrunrationalexpectationsso
longastherearenotfuturesmarketsgoingoutinfinitelyfarintothefuture(whichthereobviouslywerenot),or
equivalently,solongasthereisnotperfectforesightextendinginfinitelyfarintothefuture.SeeHahn(1966)and
ShellandStiglitz(1967).
42
If,ofcourse,acrisishadbeenwidelyexpected(atsomeearlierdate),thenconsumptionwouldhavefallenat
thatearlierdateandthedownturnwouldhaveoccurredatthatearlierdate.
43
Seetheearliercommentsonvariableratemortgagesandthereferencescitedthere.

23

RBCmodelsemphasizetechnologyshocks.IntheNewKeynesianmodelsofeithervariety,monetary
policyshockscanalsohaveimportantconsequences.44Butthefirsttwostrands,withtheiremphasison
rationalexpectations,ruleoutthemostimportantsourceoffluctuations:Deepdownturnsarecaused
byshockstotheeconomycreatedbytheeconomyitself.Thebehaviorgivingrisetotheshockstypically
isassociatedwithirrationalbehavior,andevenwhensuchirrationalityisexploitedbyrationalactors,
theycannotfullyundotheeffects.
Finally,NewKeynesianmodelswithsomepricerigiditiesbutwithsufficientwageflexibilitysuchthat
thereisfullemployment,eveniftheymightbeabletoexplainmovementsinoutputandemployment,
havelittletosayaboutonethecentralvariablesofconcernindeepdownturns,unemployment.45
Oneconsequenceofthepervasivemarketfailuresisthattherearelargemacroeconomicexternalities
theapplicationattheaggregatelevelofthepervasivemarketexternalitiesarisingineconomieswith
imperfectinformationandimperfectriskmarketsdiscoveredbyGreenwaldandStiglitz(1986).
Macroeconomicexternalitieshelpexplainbothamplificationandpersistence.Whiletheseeffectsand
theirimplications(e.g.formultipliers)wasoriginallystudiedinthecontextofNewKeynesianmodels
withfinancialfrictions,similarresultsobtaininmodelswithpricerigidities.(FarrhiandWerning(2015).)
Deepdownturnsareoftenrelatedtoproblemsinthefinancialsector.(Onehastobecareful,however,
toavoidthesuperficialreadingofdatawhichsuggeststhatfinancialcrisesaredifferenttheylastlong
andaredeeper.Foranexample,seeRogoffandReinhart,2009.Adeepdownturn,whateverits
origins46,willeventuallyaffectthefinancialsectorasborrowerswillbeunabletopay;andwhenthe
downturnisdeepenough,therewillbeafinancialcrisisintheabsenceofgovernmentintervention.In
suchasituation,thefinancialsectormaybeanimportantpartoftheprocessofamplificationand
persistence;butthestatementthatdownturnsinvolvingafinancialcrisisaredeeperandlastlongermay
benothingmorethanatautology,sayingnothingmorethanthatdeepandprolongeddownturnsare
deepandprolonged.
Thefinancialsectorinturncannotbeunderstoodwithinarepresentativeagentmodel;information
asymmetriesandincompletemarketsarecentral.Macroeconomicexternalitiesariseespeciallyinthe
financialsectorandhighlightwhyoneneedstostudycarefullythestructurewithinthefinancialsector

44

Therearealsosomemodelswhichintroducedemandshocksofanotherkind(Lorenzoni,2006,2011).
Consumersandfirmsexpectationsarebasedonnoisypublicsourcesofinformation(apublicsignal).Thenoise
componentinthissignal(i.e.thenewsshock)causesaggregatemistakesinagentsexpectationsabout
productivity.Thesemistakesleadtodeviationsofoutputfromitsnaturallevel,whichhavethetypicalfeaturesof
aggregatedemandshocks.Butunderlyingtheanalysisisatechnologyshock,onwhichisoverlaidimperfect
information.Itisnotplausiblethatsuchdemandshocksplayedanimportantroleinrecentfluctuations:as
expectationsofincreasedproductivitygrewinthelate90s,therewasnotaboomindemand,exceptforthat
producedbythehousingbubble;andtheslowdownofproductivityhasnothadtheconverseeffect.
45
ThisisacritiquethatcanbeleviedagainstsomevariantsoftheAlternativeNewKeynesianmodels.Someofthe
GreenwaldStiglitzmodels,forinstance,focusontherolethatfinancialmarketfrictionsinthepresenceofperfect
wageandpriceflexibilitygenerateemploymentfluctuations.
46
Itmay,forinstance,berelatedtothedeepstructuraltransformationsdescribedearlierinthispaper.Inthat
case,itisalargechangeintechnologythatisthedriverofthedownturn,notanunderlyingprobleminthe
financialsector.

24

(includingtheinterlinkagesamongfinancialinstitutions).Thefinancialsectorcannotbeadequately
summarizedinamoneydemandequation,asthefirsttwostrandsofmacroeconomicanalysis
attemptedtodo.
E. ContrastingPolicyImplications
Thealternativetheoriesdescribedintheprevioussubsectionsdiffernotonlyintheirinterpretationof
downturns,butalsointheadvicetheygiveconcerningappropriatepolicyresponses.Inthissection,we
lookatthreeexamples.
Monetarypolicy
Traditionally,monetarypolicyhasbeentheinstrumentofchoiceinrespondingtoeconomic
fluctuations.Butitisclear,indeepdownturns,thatitmaybeineffective,oratleast,insufficient.
Keynesexplainedthisintermoftheliquiditytrap,theinabilitytolowerinterestratesenoughto
stimulateinvestment(orconsumption)enoughtorestoretheeconomytofullemployment.Thistheme
hasbeenpickedupinsomeoftherecentliteratureundertheconceptofthezerolowerbound
nominalinterestratescouldnotbeloweredbelowzero.(Keynesalsoexplainedtheineffectivenessof
monetarypolicyinsuchasituationbyusingananalogy:itwaslikepushingonastring.)
WehavealreadysuggestedwhymatterstodayaredifferentthantheywereintheGreatDepression,
whenrealinterestrateswere10%.Obviously,ifweloweredrealinterestratesenough,wecould
presumablyrestoretheeconomytofullemploymentaninterestrateofminus100%wouldchange
matters.(Thisisequivalenttojustgivingmoneyaway;laterinthislecture,Idiscussmoneyrain.)But
thatisnotwhatthosewhoarefocusingontheZLBmean.Theyarguethatifonlywecouldlowerreal
interestrates,sayto4%(fromtheminus2percentthatitwasintheaftermathoftheonsetofthe
GreatRecession)wewouldhaverecovered.Ihaveneverseenanyconvincingevidenceinsupportof
thatcontention,andasInotedearlier,ifthereasonforthecontinuedpoorperformanceofthe
economywerethezerolowerbound(ZLBthefactthatnominalinterestratescouldnotbelowered
belowzero),intertemporalpricescouldbechangedthroughtaxpolicies.
ThecentralflawsintheanalysisofrealbusinesscyclesandtheNewKeynesianmodelswithwageand
pricerigiditiesarethat(a)theyseemonetarypolicyworkingthroughinterestrates;(b)inthesemodels,
thereisonlyonerelevantinterestrate,theTbillrate;(c)theinstitutionalarrangementsthroughwhich
creditismadeavailable(banks)makesnodifference;and(d)distributionaleffectsareassumedaway.
Wearguedbefore,though,thattherecanbecreditrationing;andliquidityconstraintsareespecially
relevantindeepdownturns.Ifthereiscreditrationing,thenmonetarypolicyaffectsaggregatebehavior
throughcreditavailability;andcreditavailabilityisaffectednotjustbyconventionalmonetary
instruments(openmarketoperations),butalsobythewholegamutofmicroandmacroprudential
regulations(suchascapitalrequirements).
Butevenifthereisnocreditrationing,whatmattersforfirmbehavioristhelendingrate,nottheTbill
rate(fewfirmscanborrowattheTbillrateevidenceitselfoftheimportanceofbankruptcyand

25

insolvency).Butthespreadbetweenthetwoisendogenous;oneofthemainobjectivesofGreenwald
andStiglitz(2003)wastoexplainthatspread.47
TheliteratureinthethirdstrandofNewKeynesianeconomicsdescribedaboveexplainsthe
ineffectivenessofmonetarypolicyinawayquitedifferentfromthatfocusingonthezerolowerbound:
Banksareunableorunwillingtolend,bothbecauseofshockstotheirnetworth(asaresultofhigher
thanexpecteddefaults)andincreasesinriskperceptions.Insuchsituations,loweringtheTbillrate(or
evenacapitalinjectionthroughpreferredshares)haslittleeffect:itmayneitherleadtoasubstantial
increaseincreditavailabilitynorlowerinterestrates.Banksmay,moreover,notpassonlowerinterest
ratestocustomers(andthismaybeespeciallysoifmarketsarenothighlycompetitive).
Moreover,monetarypolicycanhavelargedistributiveeffects,andthesecanundermineits
effectiveness.Quantitativeeasingmayhaveledtoastockmarketbubble,whichmayhaveledto(a
slightly)increasedconsumptionbytheveryrich,thoughgiventhatitwasannouncedthatthe
interventionwasonlytemporary,itwashardtounderstandwhytherewouldbesignificant
consumptionimpactsintheabsenceofsignificantimpactsonintertemporalpricesandtheseeffects
wereminimal.Buttheloweringoftheincomeofretiredpeopledependentonthereturnto
governmentbondswouldhavebeenexpectedtohaveasignificantadverseeffectontheconsumption
oftheseindividuals.
Theremaybeevenmoreadverseeffectsonthemediumterm:thelowercostofcapitalmayinduce
firmstousemorecapitalintensivetechnology,leadingtoajoblessrecovery,exertingdownward
pressureonwages.48
Fiscalpolicy49
Realbusinesscycletheoryarguedthatfiscalpolicywasnotonlyunnecessarybutineffective:withthe
economyalwaysatfullemployment,moregovernmentspendingsimplydisplacedprivatespending.Tax
cutsfinancedbydebtsimplyledindividualstosavemore.
Bycontrast,inthemoregeneralNewKeynesiantheories,fiscalpolicycanbeveryeffective;multipliers
canbelargeandindeed,theycanbeevenlargerwithrationalexpectations(ormoregenerally,with
futureorientedindividuals).Publicinvestmentcan,infact,leadtocrowdinginofinvestment,ifthereis
complementaritybetweenpublicandprivateinvestment.50Therecanbecrowdinginofconsumption,if
thereareexpectationsoffuturehigherincomes.(NearyandStiglitz,1983.)
Alargebalancedbudgetmultipliermeansthatexpansionaryfiscalpolicycanworkevenwithbudget
constraints.

47

TheyexplainwhythebanklendingrateisnotjusttheriskadjustedTbillrate.
Foramoreextensivediscussionofthesedistributiveissues,seeStiglitz(2015b).
49
Foranexcellentparalleldiscussionofhowthealternativemodelsledtoflawedpolicyconclusions,seeMason
andJayadev(2013).
50
AsseemedtobethecaseduringtheGreatDepression.SeeAlexField(2003,2011).
48

26

Still,intheNKmodelswithpricerigidities,therewasastrongpreferencefortheuseofmonetarypolicy,
exceptinthelimitingcaseoftheZLB,anditisimportanttoknowwhy.Itislargelyisbecausethe
fashionableversionsofthesemodelsaredesignedtoexhibitRicardianequivalence.
Ricardianequivalence
Forinstance,ataxcutfinancedbygovernmentborrowinginducesindividualstosavemore,torepaythe
liabilitywhichtheywillhavetopayinthefuture.Consumptionisunchanged.Theconditionsunder
whichRicardianequivalenceholdsare,ofcourse,veryrestrictive,buttheNKmodelswithpricerigidities
typicallyembraceallofthespecialconditionsrequired.WhileStiglitz(1988)showedthatRicardian
equivalenceholdsundermuchmoregeneralconditionsthanthoseassumedbyBarroandforamuch
widerrangeofpublicfinancialoperationsitdidnotholdwhentherewascreditrationingorother
formsoffinancialrestraints.Nordiditholdingeneralinmodelswithfinitelivedindividuals.
Butevenwithintheinfinitelifetimedynasticmodelswithperfectmarkets,Ricardianequivalence
doesnthold,aswenotedabove,ifpublicspendinggoesforpublicconsumptionthatarenotperfect
substitutesforprivateinvestmentgoodsorforpublicinvestmentgoodsthatarenotaperfectsubstitute
forprivateinvestmentgoods,andthisistruewhetherthereismarketclearingornot.
ThereisasecondreasonthattherigidpriceNKmodelswithfullemploymentfocusonmonetary
policyseenaschangingintertemporalchoices.Considerthelimitingcasewherethereisnolabor
supplyelasticity.Theninsuchmodels,incomesarefixed.Thatmeansthatifwearetoachievefull
employmenttoday,wesimplyhavetoshiftenoughoflifetimedemandintothecurrentperiod;with
someintertemporalsubstitutionwecanalwaysdothat.Ifwecanjustadjustrealintertemporalprices
correctly,wecaneasilyachievefullemploymenteveryperiod.Thepricerigiditiesmeanthatwelfare
maynotbeashighasitwouldbeinthefirstbestworldofRBC;butatleast,wehavesolvedthe
macroeconomicproblem.(Withvariableemployment,mattersareslightlymorecomplicated,because
therecanbeincomeeffectsfromthechangesinintertemporalprices,asindividualsdecidetosupply
moreorlesslabor.)
Reducedpayrolltaxes
Theconsequencesofatemporaryreductioninthepayrolltaxillustratethesensitivityofresultsto
particularassumptions.Assumethatthereisatemporaryshiftindemandawayfromthepresent,that
leavesaggregatedemandtodayweak.Inmodelswithwageflexibility(evenNKmodelswithrigidprices)
wageswillfalluntilmarketsclear,andemploymentdecreases.Inmodelswithrigid(real)wages,there
willbeunemployment.Assumethegovernmentwishestosmoothoutthefluctuationbyreducingthe
payrolltax.Standardtheorysaysitdoesntmakeanydifferencetothecompetitiveequilibriumon
whomthetaxislevied,whethertheworkerorthefirm;butinthediscussionbelow,wefocusonhowin
theshortrun,adjustmentsdifferandthatmattersfortheshortrunequilibrium.Consideran
institutionalarrangementwherethepayrolltaxispaidbyworkers,andthereducedtaxincreasesthe
paycheckreceivedbytheworker.WithRicardianequivalence,theworkersavestheentireamount.In
reality,hedoesntpartlybecausehemaybefinanciallyconstrained,partlybecauseheassumesthe
debtswillbepaidbysomeoneelsesgreatgrandchildren.Ifworkersspendmore,aggregatedemand
27

increasesandunemploymentfalls.InNKmodelswithfullemployment,itisthesupplysideeffectthat
dominates:atthehigherrealwage,workerswanttoworkmore.Thereisashiftinthedemandand
supplycurveforlabor.Ifthepayrolltaxcutistemporary,littleoftheextraincomewillbespentthis
period,sothedemandeffectislimited,andthesupplyeffectmaybelargerthisperiodofhighaftertax
wagesisagoodtimetowork.Toaccommodatethegreaterlaborsupply,thewagepaidbythefirm
mustfall.Thereisthussomeredistributioneffect;butinrepresentativeagentmodels,wherethe
workeralsoownsthefirm,theseredistributiveeffectscanbeignored.
Thereisaproblem:ifthereisalargelaborsupplyelasticityandlittleextrademand,therewillbean
excesssupplyoflabor.Normally,monetarypolicycanaccommodatethis,shiftingdemandforward.But
withtheZLB,thisisnotpossible.Hence,themaineffectofthepayrolltaxcutistolowerbeforetax
wages,leavingaftertaxwageslittlechanged.Thepayrolltaxcutisnotveryeffective.
Thisassumes,ofcourse,thatpricesdontadjust.Butifthereissomepriceflexibility,thelowerwage
thatresultsinducesaslightlylowerprice(thosefirmsthatcanlowerpricesdoso),andthisinduceseven
morefirstperiodconsumption.(Inprinciple,weneedtoconsiderfurtherreactionsonlaborsupplyand
consumptioninlaterperiods,andhowthesereverberatebacktothefirst.Weassumethesesecond
roundassumptionsareofsecondorderimportance.)
ThealternativestrandofNKmodelsarguesthatthisanalysisunderestimatestheeffectsonemployment
by(a)underestimatingthecurrenteffectonaggregatedemandbyassumingRicardianequivalenceand
ignoringtheroleoffinanceconstraintsformostindividuals;and(b)overestimatesthelaborsupplyside
effect.51Outputincreases,notbecauseworkersarewillingtoworkmore,butsimplybecausethereis
moredemand.Theseeffectsareespeciallymarkedinaworldwithwageandpricerigidities,sothatin
theinitialsituation,thereisunemployment.Thelaborsupplyeffectisthenlargelyirrelevant.
Inthecasewherethereissomepriceflexibility,thealternativestrandofNKmodelswouldsuggesttoo
thattheintertemporalsubstitutioneffectshiftingconsumptionforwardintimeisoverestimated.At
thesametime,soaretheimplicationsoftheZLB.
IntheFisher/Greenwald/Stiglitzmodelswithpriceflexibility,thereis,however,aslightlyoffsetting
effect:atransferofwealthasaresultofthelowerpricesfromdebtorstocreditors,andthisdiminishes
themagnitudeofthemultiplier.52
Butnowassumethatthetaxisimposedontheemployer,andthusheseesthecostoflaboraslowered.
Ifpricesremainunchanged,asintheNKfixedpricemodels,hisprofitsincrease,andtheownersofthe
firmarewealthier;buttheyseethatasbeingoffsetbythesameamountastheirfuturetaxliability.

51

Thisisespeciallysointhepresenceofrealwagerigidities:inperiodsofhighunemploymentworkerstypicallydo
notjointhelabormarket,evenifwagesareslightlyhigher(thoughthereissomeliteraturesuggestingthat
unemploymentcan,undersomecircumstances,elicitanevengreaterincreaseinlaborsupplyasmorefamily
membersstruggletofindajob.SeeBasuetal2002andthereferencescitedthere.Iftherewerealaborsupply
sideeffect,itcouldhaveasignificantadverseeffectonaggregatedemandbecauseoftheadversedistributive
effect.
52
Note,however,thatifthecreditorsareconstrainedintheirlending,e.g.bycapitalrequirements,theycan
expectlending,andthiseffectcouldpredominate.

28

Laborischeaper,sotheyincreasetheirdemandforlabor,andthisdrivesupthewage.Thereare
redistributiveconsequences,butinarepresentativeagentmodel,thesedonotmatter.Butagain,with
theaftertaxwagelower,ifthereissomeflexibilityinprices,pricestodaywillfall,andthiswillshift
consumptionforwardintime,withalltheconsequencesthatwepreviouslydescribed.
Again,comparedtotheotherNKmodels,thedemandeffectsmaybeunderestimated,becauseofthe
assumptionofRicardianequivalence,oroverestimated,becauseoftheabsenceofredistribution
effects.Sotoo,theanalysisunderestimatesthebenefitsfromthestrengtheningoffirmsbalance
sheets,whiletheintertemporalsubstitutioneffectsareoverestimated.
Thepointofthislengthyexerciseistoemphasizethattheresultsofanypolicychangecandepend
criticallyontheassumptions,aboutwhatconstraintsarebinding,aboutlaborsupplyelasticitiesand
intertemporalsubstitutability,andaboutthemagnitudeofredistributiveeffects.53
Theachievementofmodernmacroeconomicsinrecentyearsistoconstructmodelswithinwhicha
widerangeofpoliciescanbedebated.Thequestionthenbecomes,whatarethemostplausible
models?Whichonesbestcapturewhatisgoingon?Inconstructinggoodmodelsofdeepdownturns,
whatmattersisnotsomuchhowwellthemodelworksingoodtimes,buthowwellitexplainsthe
detailsofwhatweobserveintheserarebuthighlyimportantsituations.
OpenEconomies
Theanalysisofsmallopeneconomiesoffersmanyadvantages:pricescanbetakenasgiven,countries
canborrowandlend,etc.Buttherearesomedifficulties:asmalladjustmentofexchangerateswould
normallyconfronttheeconomywithunlimiteddemands.How,then,canaggregatedemandbea
problem?
GreenwaldandIinourjointworktookoneapproach:wefocusjustondomesticsupply.With
imperfectionsinfinancialmarkets,theamountthatfirmsarewillingtoproduce,theamountsthatthey
arewillingtospendoninvestment,andtheamountoflabortheyarewillingtohirewillbelimited.We
focusedonhowthesevariableswereinterrelatedandwouldbeaffectedbyvariousshocksandpolicies.
GuzmanandIinourjointworkhavetakenanotherapproach:thereisalargenontradeablesector,and
resourcescannotmoveperfectlybetweenthetradeableandnontradeablesector.Theirmodelshelp
usunderstandbetterthefailureofprogramsofausterityinGreeceandmanyoftheothercountriesin

53

ThusEggertsson(2011)presentsanelegantNKDSGEmodelwithfixedpricesinwhichheshowsthatlabortax
cutsarecontractionaryinthepresenceoftheZLB.Butwhilehecallsitamicrofoundedmodel,itisavery
specialmodel,inwhichRicardianequivalenceholds,therearenofinancialconstraints,andindividualslive
infinitelylong.WhileheusestheDixitStiglitzmodel,akeyfeatureofthatmodelismonopolisticcompetitionwith
constantelasticitydemandcurves,animplicationofwhichisthatprices(netoftaxes)areafixedmarkupover
costs(grossoftaxes).Andyet,ashesays,inthemodelAnimportantassumptionisthepricethefirmsetsis
exclusiveofthesalestax.(p.6667).Moreover,whiletheremaybeanormalprocessofpriceadjustment(ina
Calvotypemodel),itseemsarbitrarytoassumethatthepatternofpriceadjustmentseitherforaonceandforall
oraonetimetaxchangewouldbethesameasthatforthoseinducedbyotherchangesinfactorcostsordemand.

29

theeurocrisis.Itwashopedthatausteritywouldleadtowageandpricedecreases;lowercosts,itwas
thought,werenecessarytoincreasecompetitiveness,inthepresenceofexchangeraterigidities.
Butthereareadverseeffectsonnontradedgoodsdemand,especiallysincesomeofthedistributive
benefitsoflowerwagesaregarneredbytheforeignownersofthefirmswithinthecountry54;andtheir
gainsdonotleadtoincreasesinthedemandfornontradedgoods.Theseadverseeffectsonthenon
tradedgoodssectorcanmorethanoffsetanybenefitsfrominternationalcompetitiveness.Evenworse,
theincreasedbankruptcyamongproducersofnontradedgoodshasspillovereffectsonproducersof
tradedgoods(e.g.throughthebankingsystem),andtheseeffectscanbesolargethattheremaybeno
increaseinexports.ThishappenedduringtheEastAsiacrisis,and,morerecently,inGreece.
Debtpolicy
Thethirdareaofpolicyisonewhichhasbeengivenshortshriftbyeconomists,butseemsespecially
relevantinthecurrentcontext,wheremanyeconomiesseemplaguedwithexcessleverage.The
processofdeleveragingandrestoringbalancesheetsisslow.Debtrestructuringmaybeaneffective
wayofrestoringaggregatedemandmorequickly.
Standardeconomicmodelswouldhavesuggestedthatsuchdebtrestructuringwouldhavelittleeffect:
someindividualswealthhasincreased(thosewhosedebtshavebeenwrittendown),butothershave
decreased.Itissimplyamatterofredistribution.
Butaswearguedearlier,suchredistributionsdomatter.Theincreaseinspendingbythosewhosedebt
hasbeenreduced(whonowfacealessbindingfinancialconstraint)morethanoffsetsanyreduced
spendingbythecreditors.Infact,becauseofwhatwereferredtoearlieraspseudowealth,thelatter
effectmaybeparticularlysmall:thecreditorshad,inanycase,dimexpectationsofbeingrepaid.There
isapositiveincreaseinthevalueofaggregateperceivedwealth.
Inflationusedtobeaneffectivewayofdebtrestructuringinrealtermsthedebtsofthedebtorsgot
writtendown.Butthisapproachnolongerseemsacceptable.
InStiglitz(2010a)Iarguedthatgovernmentshouldhaveenactedahomeownerschapter11thatwould
haveallowedunderwaterhomeownerstodoadebtforequityswap.Therewasenormousdeadweight
lossfromtheforeclosureprocess(andmoreinequitiesthaneventhecriticshadanticipated,asaresult
oftherobosigningscandal,wherethebanksfalselysignedthousandsofaffidavitsconcerningthedebt
obligationsofhomeowners).Therewasenormousresistancefrombanks,whowereworriedaboutthe
consequencesofthedebtwriteoffs,eveniftheyweresimplyrecognizinglossesthathadalready
occurredaccountingreformshadallowedthebankstopostponetherecognitionoftheselosses.

54

Toavoidtheseimportantdistributiveeffects,mostoftheNKrepresentativeagentliteratureassumesthat
foreignerslendbutdonotinvest,anassumptionwhichisincreasinglyunrealisticinourglobalizedeconomy.

30

TheObamaAdministrationrefusedtosupportthisreformwhichwouldhavehelpedrejuvenatethe
economypartoftheiralmostsinglemindedfocusonsupportingthebanks55.
Contestabledemocracies
Economistshavetraditionallydividedpolicyanalysesintotemporaryandpermanentchanges.Butin
therealworld,theremaybeadisparitybetweenwhatthegovernmentannouncesandwhatagentsin
theeconomybelieve,andforgoodreason:inademocracy,eachgovernmenthasonlyalimitedability
tocommitfuturegovernments,andmarketparticipantsknowthis.Sometimes,governmentsactively
participateinthecharade:theBushAdministrationannouncedatemporarycutintheestatetax(down
tozeroinoneyear).Itdidthisbecauseofbudgetrules,accordingtowhichthecountrycouldntafforda
permanentcut.ButtheBushAdministrationclearlybelievedthatthepoliticaleconomywassuchthat
oncethetaxratereachedzero,itwouldbedifficulttoraiseitagain.
Intheprevioussections,wehaveconsideredvariousmeasuresdesignedtohelptheeconomygetoutof
adeepdownturn.Typically,themeasuresareannouncedastemporary.Buttheeffectsofthe
measuresdependonbeliefsaboutfuturepolicy.KorinekandStiglitz(2008)haveexploredhowthose
beliefsaffectbehaviorofmarketparticipants,howtheknowledgeofthosebehavioraleffectsthe
behaviorofpoliticalactors,andthestochasticequilibriumwhichthusarisesincontesteddemocracies.

55

Reinforcedbyaconcernthatifthebankswereforcedtorecognizethelosses,theymightneedmoremoneyfor
recapitalization.

31

III.
Thecapitalisteconomyasacrediteconomy
Thepreviouspartofthislecturehasarguedthatanunderstandingofthefinancialmarketneedstobeat
thecenterofanyanalysisofdeepdownturns.Earlierworkemphasizedtheimportanceofinformation
asymmetriesandtherolethatparticularinstitutions,suchasbanks,playindealingwiththeseproblems.
The failure of much of the standard macroeconomic literature to deal with finance and these deep
seated information problems accounts for much of the failure of modern macroeconomics, and the
failure of policy makers to adopt regulatory frameworks that might have prevented the latest deep
downturn. For instance, they bought into the completing the markets agenda, suggesting that
structured financed and securitization was leading to a more efficient marketwithout enquiring
whetheritinfactwasleadingtoamoreefficientdistributionofriskandwithoutaskingwhetherthere
was an attenuation in informational incentives. They seemingly did not understand how new moral
hazard problems were being createdfor instance, incentives to create defective mortgages were
increased,andthemarketrespondedtotheseincentives.Nordidtheyunderstandhowbyopeningup
new betting opportunities, these market innovations were actually increasing market volatility.
(GuzmanandStiglitz,2014,2015a,2015b.)

In this part of the lecture, I want to revisit one aspect of the financial sector which has proved
particularlyproblematic:theprovisionofcredit.Itwasevidentafterthecrisisthatprivatemarketsdid
notdoaparticularlygoodjobintheallocationofcredit;andsimilarcriticismscouldberaisedinearlier
crises.

Thecentralroleofcredit
Traditional monetary economics has focused on money, but in our earlier work, Greenwald and I
emphasizedwhatwasreallyimportantindeterminingaggregatebehavioriscredit.Typically,changesin
money and credit are highly correlated, which is why econometric analyses typically show a high
correlationbetweenmoneyandthelevelofeconomicactivity.Butespeciallyincrises,centralbankscan
expandbasemoney,butthesupplyofcreditmaynotrespondinwaysthattheynormallydo,withthe
result that economic activity does not expand. Keynes was right in emphasizing the inefficacy of
monetarypolicyinsuchcircumstances;buthewaswronginattributingthattoaliquiditytrap,atleast
asheconceivedofit,duetoahorizontaldemandcurveformoney.Rather,wearguethatitisrelatedto
the unwillingness of banks in such circumstances to increase the supply of credit, even though the
constraintsthatnormallylimittheirsupplyhavebeenreduced.

Beyondthecorneconomy:creditcreationinamoderneconomy
Inourearlierwork,wearguedthatthetraditionalargumentthattheroleofbankingasintermediating
betweensaversandinvestorswassimplywrong,atleastforamoderneconomy.56Thesimplemodelsof
financialmarketsasintermediatorsprovideadescriptionofacorneconomy,wheresomefarmershave
moreseedthantheywanttoplantorconsume,andotherswanttoconsume/plantmoreseedthanthey
have.Inthissimpleeconomy,thosewithexcessseedbringthatseedtothebanks,whichintermediate
betweenthesaversandtheinvestors.Inthisworld,agoodsystemofintermediationissimplyonewith

56

ThispartofthelecturedrawsheavilyuponGreenwaldandStiglitz(2003).

32

low transactions costs. Markets clear the demand and supply of seed: the interest rate serves to
equilibratethetwo.57
Butthismodelprovidesapoordescriptionofoureconomytoday.Whatenablesindividualstospend
morethantheresourcestheyhaveavailable(eitherforconsumptionorinvestment)isaccesstocredit.
Creditisdifferentfromordinarycommodities.Inparticular,creditcanbecreatedoutofthinair.Ifthe
bankgivesmeapieceofpaperwhichothersaccept,Icanbuygoodswithit,increasingaggregate
demand.Thebankcancreatethesepiecesofpaperalmostatwill.(Therearelimits,whichIshall
discussinasecond.)Butthisismarkedlydifferentfromtheseedeconomydiscussedearlier:thebank
thencouldonlylendoutseedsifsomeoneelsehaddepositedtheseedsineffect,hadlenttheseedsto
thebank.
Macroeconomicconsequencesofchangesincreditavailability
Withaggregatedemanddependingoncreditavailability,changesincreditavailabilitycanhave
macroeconomicconsequences.Forreasonsthatwehavealreadyexplained,adjustmentsinpricesdo
notinstantaneouslyoffsettheseincreasesincredit.Moreover,thereisnopresumptionthatthemarket
supplyofcreditwillensureaggregatedemandequalingaggregatesupply.Akeyfunctionofmonetary
policyistoprovidetherequisitecoordination:toensurethattheaggregatedemandforgoodsequals
theaggregatesupply.Intheseedeconomy,therewasnoneedforthistheinterestrateadjustedto
makesurethatthedemandforseedequaledthesupply.
Trustasthebasisofcredit
Thisposesthecentralquestion:whatlimitsthebanksprovisionofcredit;andwhatwouldlimititinthe
absenceofconstraintsimposedbymonetaryauthorities?
Acrediteconomyisbasedontrust,andinparticular,trustthatthemoneythatisborrowedwillbe
repaid;andtrustthatthemoneythatisreceivedwillbehonoredbyothers.Ifafinancialinstitutionis
trusted,itcancreatemoney(credit)onitsown,issuingIOUsthatwillbehonoredbyothers.(Itcan
therebyincreaseeffectivedemand;butifthebankisrelativelysmall,itwillnottakeintoaccountthese
macroeconomicexternalitiesofitsactions.)
Intheoldmodelofacrediteconomy,therewasastrongsystemofaccountabilityforbanksissuing
IOUs.Therewasunlimitedliability.Ifthebankissuedloansthatarenotrepaid,theownersofthebank
wouldsuffertheconsequences.
Buttheoldmodeloftendidntwork.Theabilitytopunishbanksandbankersforbadlendingwas
limited.Andtheseproblemsbecameworsewiththeevolutionoflimitedliability,whichwasnecessary
andinevitableastheeconomybecamemorecomplexandthebanksbecamelarger.Itwasvirtually
impossibleinaverylargepartnershipforeachpartnertomonitortheothers;withunlimitedliability
partnerships,eachpartnerwasfullyaccountableforthemistakesofalltheothers.(Greenwaldand

57

ThisisformalizesDennisRobertsonstheoryofloanablefundsasthebasisofthedeterminationoftheinterest
rate.

33

Stiglitz,1992.)Withlimitedliabilityitwasdifficultessentiallyimpossibletoholdthosein
corporationsaccountable.Buttheverysizeofthebanksthemselvesmadeitalsonearlyimpossiblefor
depositorstoeffectivelymonitorthebank.Andtheseproblemswereexacerbatedbyincreasing
complexityoffinancialsystemtothepointwherenotevenfinancialregulatorsseemcapableof
assessingthefinancialpositionoffinancialinstitutionswithmultipleinstancesofabankscollapsejust
shortlyafteritssupervisorshadgivenitacleanbillofhealth.Inshort,noonecanreallymonitorthe
largebanks.
Theresult,evenbeforethefinancialsectorreachedanythingnearthecomplexityofthatoftoday,was
episodicfinancialpanics,aspeoplerushtowithdrawfundsfromfinancialinstitutionsthathadlosttheir
trust.Thesuddendisappearanceofconfidencecouldleadtomacroeconomicfluctuations.
Inamoderneconomy,thegovernmentstandsbehindtrustinthefinancialsystem
Today,underlyingtrustinthefinancialsystemisthebeliefthatgovernmentwillcometotherescue,
thatitisableandwillingtodoso,andthatgovernmentisadequatelyregulatingthefinancialsystem.
Thus,thecreationofdepositinsurancehelpedpreventruns,andthestrongregulatorysystemprovided
confidenceinthesystemasawhole.
AfterthenewregulatorysystemwascreatedintheaftermathoftheGreatDepression,wewentfor
decadeswithoutafinancialcrisis.Butthentwothingshappened:first,thefinancialsystemgotbetter
inevadingtheregulations;andsecondly,theyexercisedtheirpoliticalinfluencetostripawaymanyof
theregulationswhichhadworkedsowellarguinginpartthatbecausewehadnthadacrisis,they
werenolongerneeded(wheninfact,wehadnothadacrisispreciselybecausewehadhadthese
regulations).Moreover,theyusedtheirpoliticalinfluencetoputinplaceregulators,likeAlan
Greenspan,thelongservingchairmanoftheFederalReserve,thatdidntunderstandtherationale
behindregulation,anddidntbelievethatregulationwasnecessary.
Bankersmoralhazard
The(realistic)beliefthatgovernmentwillcometotherescueexacerbatesthemoralhazardproblem
banksknowthatiftheymakehighinteresthighriskloans,ifthingsworkoutwell,theywalkawaywith
theprofits;ifthingsturnoutbadly,thegovernmentpicksupthelosses.(Ihavedescribedthisasa
systemofersatzcapitalismprivatizinggainsandsocializinglosses.(Stiglitz(2010a).)Ishould
emphasizethattheproblemthatIamemphasizingisthedistortionofbanksincentives.Somehave
talkedabouthowdepositinsuranceattenuatesdepositorincentivestomonitorbanksandhaveeven
arguedonthesegroundsthatthereshouldbenodepositinsurance.Ibelievethisiswrong:no
depositorcouldpossiblymonitoraninstitutionascomplexasCitibank.Iftheindividualattemptedtodo
so,hewouldhavenotimetomakeanymoneytodepositintothebank.Aswenotedearlier,noteven
fulltimeregulatorshavedoneaverygoodjob.

34

Morefundamentally,monitoringisapublicgoodalldepositorsbenefitfromensuringthatthebank
behaveswell;andhencebankregulationandsupervisionshouldbepubliclyprovided.58
Themoralhazardproblemis,ofcourse,worseforfinancialinstitutionsthataretoobig,too
interconnected,andtoocorrelatedtofail.Butnotethatthefinancialsystemhasincentivestocreate
suchinstitutions.Ifabankistoobigtofail,itcanobtaincapitalatalowerinterestrate(sincedepositors
knowthatitwillbebailedout);andthisenablesittoexpand,unlessthegovernmenttakes
countervailingmeasures,suchascharginghigherdepositinsurancepremiums.Sotoo,bankshavean
incentivetobecomeinterconnected,sufficientlyenoughsothatthegovernmentcannotallowthemto
fail.
Therearefurtherproblemswiththetoobigtofailbanks:theyaretoobigtobemanaged,andtoobig
tobeheldaccountable.Thus,evenwhentheywerefoundtohaveviolatedthelaw,enforcement
actionsweremuted,simplybecausetherewasaworryaboutthemacroeconomiceffectsofstronger
actions.Perhapsmostimportantly,thesebiginstitutionscanhavedisproportionatepoliticalinfluence
shapingregulations,thechoiceofregulators,bailouts,andevenenforcementactions.Evenwhenthe
banksweretoobigtofail,onecouldhaveletthebankers,shareholders,andbondholdersgo.Butthe
bigbankswereabletousetheirinfluencetoensurethatthisdidnothappen.
Allofthisdistortsthefinancialmarkets:intheabsenceoftightregulationandoffsettinggovernment
measures,itleadstoexcessiverisktaking,badlending,andexcessivevolatility.Banksexpandnoton
thebasisoftheirefficiency,butsimplybecauseoftheadvantageofsize.Theyundertakecontracts(like
derivatives)notbecausetheyrepresentefficientrisksharing,butbecausetheyhelpcreateasystem
wherethebankistoointerconnectedtofail.
Distortionsintheflowoffunds
Ofcourse,thebeliefthatabankwillberescuedistemperedbythegovernmentsabilitytorescue,
givinganadvantagetobanksfromrichcountries.Theimportanceofthisissuggestedbythestrong
correlationbetweentheCDSsofsovereignsandofthebankswithinthegivencountry.Thishelps
explainwhyafterthe2008crisisbrokeout,moneywenttotheUS.ItwasnotbecauseAmericanbanks
haddemonstratedabetterabilitytomanageriskquitethecontrary,theyhaddemonstratedtheir
incompetence.ButtheUSgovernmenthadalreadycommitteditselftoa$700billionrescue,anditwas
clearthatmoremoneywouldbeforthcomingifneeded.Americahadboththeresourcesandthe
politicaleconomy(withthefinancialsectorexertingenormousinfluence,especiallyontheCentral
Bank,butalsoontheTreasury)toensureabailout.Confidenceinarescuewasnotsurprisinglyfar
greaterthanintheweakereconomiesoftheemergingmarkets,orevenmostofthoseinEurope.
Macroeconomicvolatilityandchangesincreditavailability
Here,ourfocusisoncreditandmacroeconomicvolatility.Suddenchangesincreditavailabilitycan
resultfromsuddenchangesintrust,suddenchangesinbanksperceptionsofrisk,orsuddenchangesin

58

Moreprecisely,becausealldepositorsinthebankbenefit,thecostsofthismonitoringshouldbebornebythese
depositors.

35

banksbalancesheets(actualandperceived).59Thesechangesinbanksbalancesheets,inturn,can
occurasaresultofchangesinmarketprices,indefaults(actualoranticipated),orwhatGuzmanandI
refertoaspseudowealth:Therecanbechangesinexpectedfutureprofitsasaresultofchangesin
beliefsorchangesinopportunitiestomakeprofitsfromothers(e.g.inderivativemarkets)becauseof
differencesinbeliefs.Alloftheseaffectbankswillingnesstolend.Inaddition,accountingrules
combinedwithbankingregulationsaffectbanksabilitytolend.Atvarioustimesandforvariousbanks,
oneconstraintortheothermaybebinding.
The2008crisisprovidedanexampleofasuddenchangeinwillingnesstolendaliquiditycrisis.Banks
cametodistrustotherbanks;theyknewthattheydidntevenknowthestateoftheirownbalance
sheet,sohowcouldtheyknowthatofotherbanks,sotheinterbanklendingmarketdriedup.Thecrisis
alsoshowedtheimpactofregulatoryconstraintsandaccountingrules.Thegovernmentshiftedfrom
marktomarkettowhatIcalledmarkingtohopetheywereallowedtopostponewritingdownthe
valueofmortgagessolongastherewassomehopethattheymightberepaid.
TheFundamentalMacroeconomicasymmetry
Asuddenchangeinaccesstocreditcangiverisetomacroeconomicfluctuationsbecauseofa
fundamentalasymmetry:Thelossofwealthorpurchasingpower(accesstocredit)mayforcethose
whowanttospendmorethantheirincometodecreasespendingintandem,whilethosewhogainin
wealth(andhaveaccesstocredit)donothavetoincreasespendinginacorrespondingway.
Thereisasimilarsituationintheinternationalcontextwhichisfamiliartoallofus;butinterestinglythe
analogyanditsimplicationshavenotbeennoted.Therehasbeenmuchworryinrecentyearsabout
globalimbalances.Ofcourse,thesumofthedeficitsintheworldmustequalthesumofthesurpluses.
Instandardeconomictheory,wheredistributiondoesnotmatterandtherearenofinancialconstraints,
thesesurplusesanddeficitswouldnotmatter.Sowhatifsomecountryislendingtoanother?
Theproblem(whichhasbeenlongnoted,datingatleastbacktoKeynes)isthatthereisanadverse
effectonglobalaggregatedemandfromsurpluses.Thedeficitcountriesareforcedtocontract
spending,whilethesurpluscountriesdonothavetoexpandtheirs.Agood,wellfunctioningfinancial
system(workinginaworldwithperfectmarkets)wouldeasilyrecyclethesurpluses,lendingittoothers,
sothattherewouldbeglobalfullemployment.Butglobalfinancialmarketsoftenfailtoworkthisway.
Thesurplusesinthesurpluscountriesaccumulateinreserves,decreasingglobalaggregatedemand.It
usedtobethatsomedeficitcountrieswouldengageinunbridledspending,andthiswouldoffsetthe
deficiencyinaggregatedemandarisingfromthesurpluscountries.Butoverthepastquartercentury,
deficitcountrieshavebecomemoredisciplined;eventhosethatcouldborrowhavecurbedtheir
spending.Andthustheworldhasemergedintoasituationwherethereisadeficiencyinglobal
aggregatedemand.(GreenwaldandStiglitz,2010a,2010b.)
Particularlyproblematicaresuddenchanges:anincreaseinthepriceofoilincreasesthesurplusesof
theoilexportersandstrengthensthebalancesheetofoilexportingfirms.Italsoincreasesthedeficits

59

Theycan(andhave)alsoarisefromsuddenchangesinpolicy.

36

oftheoilimportersandweakensthebalancesheetofoilimportingfirms;buttheformerdonot
increasetheirspendingasmuchasthelatterareforcedto(orchooseto)contracttheirs.
Inequalitygivesrisetocorrespondingimbalances.Thoseatthebottomareborrowing(runninga
deficit),whilethoseatthetoparelending(runningasurplus.)Thoseatthebottomwhoseetheir
incomesdeclineareforcedtoreducespendingmorethanthoseatthetopexpandtheirs;thatis,that
wouldbethecaseunlesssomethingelsehappens,e.g.thecountrycreatesahousingbubble.This
allowsthoseatthebottomtocontinuetospendbeyondtheirincomeindeed,aswenotedearlierin
thislecture,thebottom80%ofAmericanswerespendingroughly110%oftheirincome.Thiswasnot,
ofcourse,sustainable,andespeciallysoiftheirspendingwasbasedonbeingabletoborrowagainst
theirhome,thevalueofwhichhadbeeninflatedbyabubble.
Thefailureofmonetarypolicy,onceagain
Wesuggestedearlier,moreover,thatthenaturaladjustmentprocessesmaybe,atleastintheshortrun,
disequilibrating.Ifthecontractionofaggregatedemandleadstounemploymentandthatleadstolower
wages(aswhat,infact,happened),thenaggregatedemandisdecreasedevenastheeconomyattempts
toequilibrate.
Easingofmonetarypolicymaynothelp,oratleasthelpmuch.Earlier,weexplainedthatwhataffects
borrowersbehaviorisnottheTbillrate(therateatwhichthegovernmentcanborrow),buttherateat
whichtheycanborrow,andthespreadisanendogenousvariable.Moreover,manyborrowersface
creditconstraints,andcreditavailabilityisalsoanendogenousvariable.Easingofmonetarypolicymay
nothelpsimplybecauseitmaynotleadtomuchofanincreaseincreditormuchimprovementinthe
termsatwhichcreditismadeavailable.
IndeedtheeffectofloweringinterestratesTbillratesmayitselfbeambiguous.Targetsavers(those
whoaresavingforpurchasingahome,financingacollegeeducation,orforretirement)willactually
increasetheirsavingandretireesdependingonincomefromgovernmentTbillswillreducetheir
consumption.60Thereare,ofcourse,someoffsettingeffects.Lowerinterestrateswillleadtoan
increaseinthevalueofshares,andthiscouldbeexpectedtoleadtoanincreaseinspendingofthe
wealthy.Thequestionis,howinterestsensitiveisconsumptionoftheverywealthy?Howmuchwill
theyincreasetheirspending,especiallyifinterestratereductionsareexpectedtobetemporary?Ifa
newpolicyregime(e.g.quantitativeeasing)introducesnewmacroeconomicuncertainties,itiseven
possiblethattheconsumptionofthewealthyisreduced.Asithasturnedout,inspiteofrecordlow
interestrates,theaggregatesavingsratehasincreased,thoughperhapsnotasmuchasmighthave
beenexpectedorasmuchasitwouldhaveintheabsenceofthelowinterestrates.Oneofthereasons
thatsavingsmaybelowerthanonemighthaveexpectedisthatittakestimeforindividualstoadjust
downwardtheirlivingstandards.Someofthoseinthebottom80%seemwillingtospendbeyondtheir
means,solongasbanksorotherfinancialinstitutionsarewillingtolendtothem.Ifthetop20%,with
40%ofUSincome,saveapproximately15%oftheirincome,thenthatbyitselfleadstoanational
savingsrateof6%.Ifeventuallythebottom80%adjuststolivingwithintheirmeans,withazerosavings

60

TheseeffectsarenotpickedupatallinthestandardDSGEmodels.

37

rate(i.e.notevenpayingbackaccumulateddebts),thenwecanexpectthesavingsratetoincrease
towards6%,suggestingthattheUSrecoverywillremainweak.
Noticeherethatwhatisleadingtotheweakeconomyandthelimitedeffectofmonetarypolicyisnot
thezerolowerbound:itisthatloweringTbillinterestratessimplydoesntprovidemuchofa
simulativeeffecttotheeconomy.Banksmaynotbewillingtolendorlendatmorefavorableterms;and
lowerinterestratesmayhaveambiguouseffectsonaggregateconsumption.

Alternativeapproachestostimulatingtheeconomy
Ifloweringinterestratesorloweringwageswontleadtofullemploymentandtherestorationof
aggregatedemand,whatwill?Forsomegovernments,thereisaneasysolution:Theycancreatemoney
andcredit.Governmenthasthepowertoprintmoneyandthepowertotax,tomakegoodontheir
promises.Itisthesepowerswhichleadtotrustinthegovernmentandinthegovernmentsabilityto
bailoutbanks.
Ineffect,governmentshavedelegatedthetrustthatarisesfromthesepowerstothebanks,allowing
themtoprofitfromthedelegatedauthority.Theargumentforthatisthatprivatebankscandoabetter
jobthanpublicinstitutions,andthatthereareinevitablepoliticaleconomyproblemsinthepublic
allocationoffunds.Atbest,thatwouldbetrueifonecouldalignprivateincentiveswithpublicinterests,
andprivatereturnswithsocialreturns.ButacentralresultoftheGreenwaldStiglitz(1986)theoremis
thatwheneverthereareinformationasymmetriesandincompletemarketsthatis,always,and
especiallyinfinancialmarketstherearepecuniaryexternalitiesassociatedwithprivateactions;and
theseexternalitiesmatter,sothatmarketsarenot(constrained)Paretoefficient.
Buttherearethreeothersystematicmarketfailuresassociatedwiththefinancialsystem:imperfections
ofcompetition,theexploitationofimperfectlyinformedandoftenfinanciallyunsophisticated
consumers,andthespecialproblemsofbailoutriskthatwedescribedearlier.
Thisdelegationhasevidentlynotworkedwell:transactionscostshavebeenhigh,therehavebeen
enormousmarketabuses(frommarketmanipulationtopredatorylending,frominsidertradingand
connectedlendingtoabusivecreditcardpracticesandfraud).Theresultisthatresourceshavenot
beenwellallocated,riskshavenotbeenmanagedwellthemarketsactuallycreatedrisksandthe
financialsectorhasplayedanimportantroleintheincreaseininequality.(Stiglitz,2012a.)
Thesefailureshighlighttoothepoliticaleconomyproblemsinthedelegatedsolution:forthebanks
(andespeciallythebigbanks)have,aswehavenoted,usedtheirpoliticalpowertolimitregulation,
regulationsthatmighthavepromotedcompetitionandlimitedtheconflictsofinterest,theexploitation
ofthefinanciallyunsophisticated,andtherisksimposedonthepublic.Andtheyhaveusedtheir
politicalpowertoextractmassivebailoutsfromthepublic.Itisevidentthatpoliticaleconomy
problemscannotbeavoided.Thecurrentarrangementshavethusoftenleadtonontransparent
subsidiesanddistortions.
38

Thestandardapproach
Thestandardapproachinmonetaryeconomicstostabilizetheeconomyfocusesonenhancingthe
abilityandwillingnessofbankstoprovidecredit,throughchangesinrulesthatmaketheconstraintson
theirlendinglessbindingandthroughopenandhiddensubsidiesthatincreasetheirnetworth,andthus
theircapacityandwillingnesstolend.61Thehopeisthattheydoso,andthatthemoneygoesto
increaseeffectivedemand,ratherthanpurchasingpreexistingassetssuchasland.Itisalsohopedthat
theywillallocatethefundstouseswiththehighestsocialreturnandthattheydonttakeadvantageof
theunwary.
Thissolutionhasntworked:Banksoftenhaventlent(therealsourceoftheliquiditytraptoday),
andwhentheyhavelent,moneyhasntgonetowhereitwouldleadtoanincreaseineffectivedemand.
Indeed,giventheriskaversionofbanks,itisunderstandablethattheylendagainstcollateral(andsome
oftherulesgoverningbanksmayevenencouragethemtodoso).But,lendingagainstcollateralmeans
thattheydisproportionatelylendforrealestatepurchases.Somegovernmentsinthepast(likethatof
Thailand)restrictedsuchlendingbecausetheywantedfundstogointoproductiveuses,andtheydidnt
wanttocreaterealestatebubbles.Theywerecriticizedfordoingthistheseregulations,itwas
alleged,wereinterferingwiththemarket.
Wehavealreadyexplainedwhytheseargumentswerenave:theydidnttakeintoaccountthemultiple
marketfailuresthatwehavenoted,thedistortionsbetweenprivateandsocialreturns.Butleavingitto
themarketpresentsaspecialproblemasfarasensuringmacrostability:itispossiblethatthelevelof
creditnecessarytorestoretheeconomytofullemploymentgeneratesexcessiveincreasesinasset
prices.Andindeed,thishasoftenbeenthecase.Onewasaskingtoomuchofasingleinstrument(the
interestrate).Monetaryauthoritieshadattheirdisposalmultipleinstruments,includingthosewhich
wouldlimittheextentofrealestatespeculation.Butintheheydayofmarketfundamentalism,
beforethe2008crisis,monetaryauthoritieswerediscouragedfromusingtheseadditionalinstruments.
Wenowknowthatthatwaswrongandtheworldhaspaidahighpriceforthisideologicallydriven
policy.(SeeStiglitz2012b,2014.)
Thisanalysishelpsexplainineffectivenessofmonetarypolicyinthecurrentcrisis.Ofcourse,ifwehad
doneabetterjoboffixingthecreditchannel(abetterjobatrecapitalizingcommunitybanksand
fixingthemortgagemarket)moreoftheincreasedliquiditymighthavefounditswayintoan
increaseddemandforproducedgoods,andthusmonetarypolicymighthavebeenmoreeffective.
Ishouldemphasize,theineffectivenessofmonetarypolicythatIhavejustdescribedhasnothingtodo
withthetraditionalKeynesianliquiditytrap.Ouranalysisexplainswhatisreallygoingon:thereal
constraintiscreditavailability,andthisdependsonthebehaviorofbanks.Inadeepdownturn,itis
hardtoinducethemtolend.62

61

Ishouldqualifythis:mostofthestandardmonetaryeconomicssimplyassumestheabilityofmonetary
authoritiestodothis.Itdoesnotactuallymodelbankbehavior.
62
Recallourearlierdiscussion,wherewenotedthatKeynesanalysiswasbasedontheassumptionofahorizontal
demandcurveformoney.Nordoesithaveanythingtodowiththezerolowerboundtothenominalinterestrate

39

Thecurrentapproachnotonlyhasbeenineffective,butitisalsopoliticallyunsavory.Ithasentailed
givingmoney(atbelowmarketrates)tothosewhocausedtheeconomiccrisistorecapitalizethemin
thehopethatthistranslatesintomorelending,andnotjustintomorewealthforthebanks.Doingso
seemsunjust,especiallysincetheargumentthatitwasnecessarytosavetheeconomywasnever
verypersuasive,andespeciallysoafteritbecameclearthatlittleofthemoneygottranslatedintomore
lending,andsomeofitwentsimplytopayhugebonusestothebankers.63
Analternativesolution:PublicLending
Therearealternativesolutions.Oneistoinducebankstofocusonlendingactivities.Indeed,this
shouldhavebeenoneofmajorfociofregulatoryreform.Thesereformscenteredaroundpreventing
thefinancialsectordoingharmtoothers;moreattentionshouldhavebeenpaidtoensuringthatthe
financialsectoractuallyperformsthesocialfunctionswhichitissupposedtoperform.Bothincentives
andconstraintscanplayarole:Restrictingbanksnonproductiveactivities(likespeculation)and
providingaccesstotheFedwindowontheconditionthattheyexpandlending,forinstance,toSmalland
MediumSizedenterprises.
Anotherisforthegovernmenttouseitsowncreditcapacitytofinancehighreturnpublicinvestments
andtoaddressothermajorsocialneeds,suchasthoserelatedtogrowinginequalityorclimatechange.
Therealreadyis,ofcourse,somedirectlendingbythegovernmentinmanycountries,eveninmore
privatelyorientedsystemsliketheUS(forinstance,studentloans).Butthisshouldbegreatlyexpanded,
forinstancetomortgagelending.TheUSgovernmentalreadyunderwritesmostmortgages.Most
conventionalmortgagesarewrittenbasedonstandardscoringmethodologies,andtherelevant
informationisallwithinthehandsofthegovernment(suchaspastincomeandrealestate
transactions).64Therearelargeeconomiesofscopebothintheprocessingofthisinformationandin
collectionthroughtaxauthorities.65Thecriticismofsuchlending,asalreadynoted,isthatgovernment
isnotgoodatlending;butthereisanobviousresponse:neitheristheprivatesector;infact,arguably
nogovernmenthaseverwastedmoneyatsuchgreatcosttosocietyasawholeastheUSprivate
financialsector.Governmenthasdoneabetterjobatleastinsomeareasanddoesnotseemtohave
theperverseincentivestobehavebadlythatarepervasivewithintheprivatefinancialsector.
Moneyrain

whichhasreceivedsomuchattentionasoflate.Asweexplainedearlier,itisimplausiblethatsimplybylowering
therealinterestratefromminustwopercenttosayminusfourpercent,theeconomywillberestoredtofull
employment.Earlier,weexplainedwhyaggregatedemandmightnotbeverysensitivetochangesinrealinterest
rates.(SeeGreenwaldandStiglitz,2003,foradiscussionofboththetheoryandevidence.)
63
Thepaymentofsuchbonusesneeds,ofcourse,tobemodeled.Itisareflectionofcorporategovernance
problemsthatarepervasiveinthecorporatesector,butappearespeciallyprominentwithinthefinancialsector.
64
Thecurrentsystemreliesheavilyonwarrantiesandrepresentationsbytheprivatesectorthatthemortgages
thattheyhaveoriginatedareastheysaytheyare.Thecrisisrevealedmassivefraudonthepartoftheoriginators
andmassivebreakingofcontracts.Toenforcecontracts,thegovernmenthashadtopayhugelitigationcosts.
Directpubliclendingwouldavoidtheseproblems.
65
Thiswasoneofthemainargumentsputforwardforgovernmentincomecontingentloans.See,e.g.Stiglitz
(2015).

40

Thereisafinalalternative,proposedlongagobyMiltonFriedman66:Moneyrainsimplysprinkling
moneyaroundtheeconomy.Itwouldinducemorespending(exceptundertheunlikelyconditionthat
pricesareadjustedfully,proportionately,andinstantaneously).Thiswouldnotbeinflationary,solong
astheamountswereappropriatelycalibrated.(Moneyraincanbeviewedasthelimitingcaseof
lendingwithaminus100%interestrate.)Inmanycountries(e.g.US)theproblemisnotaninsufficiency
ofconsumption,butofinvestment,andbroadbasedmoneyrainwouldrestorefullemploymentby
encouragingconsumption.Tome,thesolutionofgovernmentusingitscreditcreatingcapacityto
increasetheproductivecapacityoftheeconomyisafarbetterwayofrestoringtheeconomytofull
employment.
IV.

Thecrisisineconomics

The2008crisiswasnotonlyacrisisintheeconomy,butitwasalsoacrisisforeconomicsoratleast
thatshouldhavebeenthecase.Aswehavenoted,thestandardmodelsdidntdoverywell.The
criticismisnotjustthatthemodelsdidnotanticipateorpredictthecrisis(evenshortlybeforeit
occurred);theydidnotcontemplatethepossibilityofacrisis,oratleastacrisisofthissort.Because
marketsweresupposedtobeefficient,therewerentsupposedtobebubbles.Theshockstothe
economyweresupposedtobeexogenous:thisonewascreatedbythemarketitself.Thus,the
standardmodelsaidthecrisiscouldntorwouldnthappen;andthestandardmodelhadnoinsightsinto
whatgeneratedit.
Notsurprisingly,asweagainhavenoted,thestandardmodelsprovidedinadequateguidanceonhowto
respond.Evenafterthebubblebroke,itwasarguedthatdiversificationofriskmeantthatthemacro
economicconsequenceswouldbelimited.Thestandardtheoryalsohashadlittletosayaboutwhythe
downturnhasbeensoprolonged:Yearsaftertheonsetofthecrisis,largepartsoftheworldare
operatingwellbelowtheirpotential.Insomecountriesandinsomedimension,thedownturnisasbad
orworsethantheGreatDepression.Moreover,thereisariskofsignificanthysteresiseffectsfrom
protractedunemployment,especiallyofyouth.
TheRealBusinessCycleandNewKeynesianTheoriesgotofftoabadstart.Theyoriginatedoutofwork
undertakeninthe1970sattemptingtoreconcilethetwoseeminglydistantbranchesofeconomics,
macroeconomics,centeringonexplainingthemajormarketfailureofunemployment,andmicro
economics,thecenterpieceofwhichwastheFundamentalTheoremsofWelfareEconomics,
demonstratingtheefficiencyofmarkets.67RealBusinessCycleTheory(anditspredecessor,New
ClassicalEconomics)tookoneroute:usingtheassumptionsofstandardmicroeconomicstoconstruct
ananalysisoftheaggregativebehavioroftheeconomy.Indoingso,theyleftHamletoutoftheplay:
almostbyassumptionunemploymentandothermarketfailuresdidntexist.Thetimingoftheirwork
couldnthavebeenworse:foritwasjustaroundthesametimethateconomistsdevelopedalternative
microtheories,basedonasymmetricinformation,gametheory,andbehavioraleconomics,which
providedbetterexplanationsofawiderangeofmicrobehaviorthandidthetraditionaltheoryonwhich
thenewmacroeconomicswasbeingconstructed.Atthesametime,Sonnenschein(1972)and

66
67

Friedman(1969).
Foramoreextensivediscussionofthispoint,seeGreenwaldandStiglitz,1987a.

41

Mantel(1974)showedthatthestandardtheoryprovidedessentiallynostructureformacro
economicsessentiallyanydemandorsupplyfunctioncouldhavebeengeneratedbyasetofdiverse
rationalconsumers.Itwastheunrealisticassumptionoftherepresentativeagentthatgavetheoretical
structuretothemacroeconomicmodelsthatwerebeingdeveloped.(Aswenoted,NewKeynesian
DSGEmodelswerebutasimplevariantoftheseRealBusinessCycles,assumingnominalwageandprice
rigiditieswithexplanations,wehavesuggested,thatwerehardlypersuasive.)
TherearealternativemodelstobothRealBusinessCyclesandtheNewKeynesianDSGEmodelsthat
providebetterinsightsintothefunctioningofthemacroeconomy,andaremoreconsistentwithmicro
behavior,withnewdevelopmentsofmicroeconomics,withwhathashappenedinthisandotherdeep
downturns.Whilethesenewmodelsdifferfromtheolderonesinamultitudeofways,atthecenterof
thesemodelsisawidevarietyoffinancialmarketimperfectionsandadeepanalysisoftheprocessof
creditcreation.Thesemodelsprovidealternative(andIbelievebetter)insightsintowhatkindsof
macroeconomicpolicieswouldrestoretheeconomytoprosperityandmaintainmacrostability.
Thislecturehasattemptedtosketchsomeelementsofthesealternativeapproaches.Thereisarich
researchagendaahead.

42

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