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Article Excerpt
APPLICATIONS OF THE NEW PARADIGM
The new theory of the firm and the foundations of modern macro-economics
Of all the market failures, the extended periods of underutilization of resources--especially human resources--is of the greatest moment, the consequences of which in turn are exacerbated by capital market imperfections, which means that even if future prospects of an unemployed individual are good, he cannot borrow to sustain his standard of living.
We referred earlier to the dissatisfaction with traditional Keynesian explanations, in particular, the lack of micro-foundations. This gave rise to two schools of thought. One sought to use the old perfect market paradigm, relying heavily on representative agent models. While information was not perfect, expectations were rational. But the representative agent model, by construction, ruled out the information asymmetries which are at the heart of macro-economic problems. Only if an individual has a severe case of schizophrenia is it possible for such problems to arise. If one begins with a model that assumes that markets clear, it is hard to see how one can get much insight into unemployment (the failure of the labor market to clear).
The construction of a macro-economic model which embraces the consequences of imperfections of information in labor, product, and capital markets has become one of my major preoccupations over the past fifteen years. Given the complexity of each of these markets, creating a general equilibrium model--simple enough to be taught to graduate students or used by policy makers--has not proven to be an easy task. At the heart of that model lies a new theory of the firm, for which the theory of asymmetric information provides the foundations. The modern theory of the firm in turn rests on three pillars, the theory of corporate finance, the theory of corporate governance, and the theory of organizational design.
The theory of corporate finance
Under the older, perfect information theory, it made no difference whether firms raised capital by debt or equity, in the absence of tax distortions. (102) This was the central insight of the Modigliani-Miller theorem. (103) We have noted how the willingness to hold (or to sell) shares conveys information, so that how firms raise capital does make a difference. (104) Firms rely heavily on debt finance, and bankruptcy, resulting from the failure to meet debt obligations, matters. Both because of the cost of bankruptcies and limitations in the design of managerial incentive schemes, (105) firms typically act in a risk averse manner (106)--with risk being more than just a correlation with the business cycle. (107)
Moreover, with credit rationing (or the potential of credit rationing) not only does the firm's net worth (the market value of its assets) matter, but so does its asset structure, including its liquidity. (108) While there are many implications of the theory of the risk averse firm facing credit rationing, some of which are elaborated upon in the next section, one example should suffice to highlight the importance of these ideas. In traditional neoclassical investment theory, investment depends on the real interest rate, and the firm's perception of expected returns. The firm's cash flow or its net worth should make no difference. The earliest econometric studies of investment, by Kuh and Meyer [1957], suggested that that was not the case. But under the strength of the theoretical strictures that these variables could not matter, they were excluded from econometric analysis for two decades following the work of Hall and Jorgenson [1967]. It was not until work on asymmetric information had restored theoretical respectability to introducing such variables in investment regressions that it was acceptable to do so; and when that was done, it was shown that, especially for small and medium sized enterprises, these variables were crucial. (109)
Moreover, in the traditional theory, there is no corporate veil; individuals can see perfectly what is going on inside the firm; it makes no difference whether the firm distributes or retains its profits (other than for taxes). (110) But if there is imperfect information about what is going on inside the firm, then there is a corporate veil, which cannot be easily pierced.
Corporate governance
In the traditional theory, firms simply maximized the expected present discounted value of profits (which equaled market value) (111) and with perfect information, how that was to be done was simply an engineering problem. Disagreements about what the firm should do were of little importance. In that context, corporate governance--how firm decisions were made--mattered little as well. But again, in reality, corporate governance matters a great deal. There are disagreements about what the firm should do (112)--partly motivated by differences in judgments, partly motivated by differences in objectives. Managers can take actions which advance their interests at the expense of that of shareholders, and majority shareholders can advance their interests at the expense of minority shareholders. The owners (who, in the language of Steve Ross [1973] came to be called the principal) not only could not monitor their workers and managers (the agents), because of asymmetries of information, but also they typically did not even know what these people who were supposed to be acting on their behalf should do. That there were important consequences for the theory of the firm of the separation of ownership and control had earlier been noted by Berle and Means [1932], (113) but it was not until information economics that we had a coherent way of thinking about the implications.
The problem of corporate governance, of course, arises both from the problems of information imperfections and the public good nature of management/oversight: if a shareholder engages in expenditures on oversight, and succeeds in improving the firm's performance, all shareholders benefit equally (similarly with creditors.) (See Stiglitz [1985b]).
Some who still held to the view that firms would maximize their market value argued that take-overs (and the threat of take-overs) would ensure that competition in the market for managers would ensure stock market value maximization. (If the firm were not maximizing its stock market value, then it would pay someone to buy the firm, and change its actions so that its value would increase.) Early on in this debate, I raised questions on theoretical grounds about the efficacy of the take-over mechanism (See Stiglitz [1972b]). The most forceful set of arguments were subsequently put forward by Grossman and Hart [1980], who observed that any small shareholder who believed that the takeover would subsequently increase the market value would not be willing to sell his shares. Only take-overs that were expected to be value decreasing would be successful. (114) The subsequent work by Edlin and Stiglitz [1995], referred to earlier, showed how existing managers could take actions to reduce the effectiveness of competition for management, i.e. the threat of take-overs, by increasing asymmetries of information.
(Proving that a firm does not maximize their stock market value is, of course, difficult, since it is hard to ascertain its opportunity set and the consequences of alternative actions. However, there are a large number of instances in which it is clear that firms do not maximize market value. For instance, closed end mutual funds regularly sell at a discount; there would be a simple action---dissolution of the firm--which would increase market value. There are a large number of tax paradoxes, (see, e.g. Stiglitz [1973b, 1982d])--actions which firms could take that would reduce the total tax bill (corporate plus individual), though there remains some dispute about the extent to which such paradoxes are due to irrationality on the part of investors or non-value maximizing behavior on the part of managers.)
Organizational design
So far, we have discussed two of the three pillars of the modern theory of the firm: corporate finance and corporate governance. The third is organizational design. In a world with perfect information, organizational design too is of little moment. In practice, it is of central concern to businesses. We have already extensively discussed the issue of incentives, how, on the one hand, information imperfections limit the extent of efficient decentralizability and how, on the other, organizational design--by having alternative units perform comparable tasks--can enable a firm to glean information on the basis of which better incentive systems can be based. (Nalebuff and Stiglitz [1983a, b]).
But there is another important aspect of organizational design. Even if individuals are well intentioned, with limited information, mistakes get made. To err is human. Raaj Sah and I, in a series of papers [1985, 1986, 1988a, 1988b, 1991] explored the consequences of alternative organizational design and decision making structures for organizational mistakes, for instance, where good projects get rejected or bad projects get accepted. We suggested that in a variety of circumstances, especially when there is a scarcity of good projects, decentralized polyarchical organizational structures have distinct advantages. (115)
Macro-economics
The central macro-economic issue is that of unemployment. The models I described earlier explained why there could exist unemployment in equilibrium. But much of macro-economics is concerned with dynamics, with fluctuations, with explaining why sometimes the economy, rather than absorbing shocks, seems to amplify them, and why their effects often persist. In joint work with Bruce Greenwald and Andy Weiss, we have shown how the theories of asymmetric information can help provide explanations of these macro-economic phenomena. The imperfections of capital markets--the phenomena of credit and equity rationing which arise because of information asymmetries--are key. They lead to risk averse behavior of firms and to households and firms being affected by cash flow constraints.
Standard interpretations of Keynesian economics emphasized the importance of wage and price rigidities, but without a convincing explanation of those rigidities. For instance, some theories had stressed the importance of costs of adjustment of prices," (116) but what was at issue was why markets seemed to adjust quantities rather than prices, and the relative costs of adjustment of quantities seemed greater than those of prices. The Greenwald-Stiglitz theory of adjustment [1989b] provided an explanation based on capital market (117) imperfections arising from information imperfections: it argued that, at least for commodities for which inventory costs were reasonably low, the risks arising from informational imperfections were greater for price and wage adjustments than from quantity adjustments. Risk averse firms would make smaller adjustments to variables, the consequences of which were more uncertain.
But even though wages and prices were not perfectly flexible, neither were they perfectly rigid, and indeed in the Great Depression, they fell by a considerable amount. There had been large fluctuations in earlier periods, and in other countries, in which there had been a high degree of wage and price flexibility. Greenwald and I [1987a, 1987b, 1988b, 1988c, 1988d, 1988e, 1989b, 1990b, 1993a, 1993b, 1995] argued that it was other market failures, in particular, the imperfections of capital markets and the incomplete contracting which provided part of the explanation for key observed macro-economic phenomena. In debt contracts, typically not indexed for changes in prices, whenever prices fell below the level expected (or in variable interest rate contracts, when real interest rates rose above the level expected) there were transfers from debtors to creditors. In these circumstances, excessive downward price flexibility (not just price rigidities) could give rise to problems. (118) These (and other) redistributive changes had large real effects, and could not be insured against because of imperfections in capital markets. Large shocks could lead to bankruptcy, and with bankruptcy (especially when it results in firm liquidation) there was a loss of organizational and informational capital. (119) Even if such large changes could be forestalled, until there was a resolution, the firm's access to credit would be impaired, and for good reason; moreover, without "clear owners" those in control would in general not have incentives to maximize the firm's value.
Even when the shocks were not large enough to lead to bankruptcy, they had impacts on firms' ability and willingness to take risks. Since all production is risky, shocks affect aggregate supply, as well as the demand for investment. Because firm's net worth would only be restored over time, the effects of a shock persisted. By the same token, there were hysteresis effects associated with policy: an increase in interest rates which depleted firm net worth had impacts even after the interest rates were reduced. If firms were credit rationed, then reductions in liquidity could have particularly marked effects. (120) Every aspect of macro-economic behavior was affected: the theories helped explain, for instance, the seemingly anomalous behavior of inventories (rather than using inventories to smooth production, which would result in countercyclical changes in inventories, inventories moved procyclically, because of the importance of cash constraints, leading to a high shadow price of money in recessions) and pricing (with the "shadow price" of capital being high in a recession, firms did not invest as much in acquiring new customers and were less concerned about losing workers, so that mark-ups increased, so that real product wages could fail, even though the marginal productivity of labor was rising.)
In short, our analysis emphasized the supply side effects of shocks, the interrelationships between supply and demand side effects, and the importance of finance in propagating fluctuations.
Theory of money (121)
A particularly important aspect of our reformulation of macro-economics is the focus on monetary economics. Traditionally, it was postulated that the interest rate was set to equate the demand and supply for money, with money being largely required for transactions purposes, and with the interest rate representing the opportunity cost of money. In modern economies, however, credit, not money, is required (and used) for most transactions, and most transactions are simply exchanges of assets, and therefore not directly related to DP. Moreover, today, most money is interest bearing, with the difference between the interest rate paid, say on a money market account and T bill rates having little to do with monetary policy, and related solely to transactions costs. What is important is the availability of credit (and the terms at which it is available); this in turn is related to the certification of credit worthiness by banks and other institutions. In short, information is at the heart of monetary economics. But banks are like other risk averse firms: their ability and willingness to bear the risks associated with making loans depends on their net worth. (122) Because of equity rationing, shocks to their net worth cannot be instantaneously undone, and the theory thus explains why such shocks can have large adverse macro-economic consequences. The theory shows how not only traditional monetary instruments (like reserve requirements) but regulatory instruments (like risk adjusted capital adequacy requirements) can be used to affect the supply of credit, interest rates charged, and the bank's risk portfolio. The analysis also showed how excessive reliance on capital adequacy requirements could be counterproductive. (123)
The theory has important policy implications. It provides a new basis for a "liquidity trap," explaining why in severe economic downturns, monetary policy may be relatively ineffective. It explains some of the recent policy failures, both in the inability of the Fed to forestall the 1991 recession and the failures of the IMF in East Asia in 1997. It shifts emphasis from looking at the Fed Funds rate, or the money supply, to variables of more direct relevance to economic activity, the level of credit, (124) and the interest rates charged to firms (and it explains the movement in the spread between that rate and the Federal Funds rate). The theory predicts that there is scope for monetary policy even in the presence of dollarization. (125)
We also analyzed the importance of credit interlinkages. Many firms receive credit from other firms, at the same time that they provide credit to still others (violating Polonius' injunction "neither a lender nor a borrower be" by being both.) The disperse nature of information in the economy provides an explanation of this phenomena, which has important consequences. As a result of these general interlinkages (in some ways, every bit as important as the commodity interlinkages stressed in standard general equilibrium analysis) a shock to one firm gets transmitted to others, and when there is a large enough shock, there can be a cascade of bankruptcies.
Growth (126) and development (127)
While most of the macro-economic analysis focused on exploring the implications of imperfections of credit markets arising out of information problems for cyclical variations, another strand of our research program focused on growth. The importance of capital markets for growth had long been recognized; without capital markets firms have to rely on retained earnings. But how firms raise capital is important for growth. In particular, "equity rationing"--especially important in developing countries, where informational problems are even greater--impedes firms' willingness to invest and undertake risks, and thus slows down growth. Changes in economic policy which enable firms to bear more risk (e.g. by reducing the size of macroeconomic fluctuations, or which enhance firms' equity base, by suppressing interest rates, which result in firm's having larger profits) enhance economic growth. Conversely, policies, such as associated with IMF interventions, in which interest rates are raised to very high levels, discourage the use of debt, forcing firms to rely more heavily on retained earnings.
The most challenging problems for growth lie in economic development. Typically, market failures are more prevalent in less developed countries, and these market failures are often associated with information problems--the very problems that inspired much of the research described in this paper. While these perspectives help explain the failures of policies based on assuming perfect or well functioning markets, they also direct attention to policies which might remedy or reduce the consequences of informational imperfections. (128)
Research
One of the most important determinants of the pace of growth is, for developed countries, the investment in research, and for less developed countries, efforts at closing the knowledge gap between themselves and more developed countries. Knowledge is, of course, a particular form of information, and many of the issues that are central to the economics of information are also key to understanding research--such as the problems of appropriability, the fixed costs associated with investments in research, which give rise to imperfections in competition, and the public good nature of information. It was thus natural that I turned to explore the implications in a series of papers that looked at both industry equilibrium and the consequences for economic growth. (129) While it is not possible to summarize briefly the results, two conclusions do stand out: that market economies in which research and innovation play an important role are not well described by the standard competitive model, and that the market equilibrium, without government intervention, is not, in general, efficient.
POLICY FRAMEWORKS
The fact that when there are asymmetries of information, markets are not, in general, constrained Pareto efficient implies that there is a potentially important role for government. The new paradigm has important implications for policy, going well beyond addressing how to prevent the creation of asymmetries of information and how to overcome them. As we have seen, asymmetries of information give rise to a host of other market failures--such as missing markets, and especially capital market imperfections, leading to firms that are risk averse and cash constrained--and policy has to deal with these indirect consequences as well. An analysis, for instance, of the incidence of taxation which is predicated on perfectly competitive markets with perfectly informed consumers and risk neutral firms, is likely to go astray.
But beyond this, the new information paradigm helps us to think about policy from a new perspective, one...
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