Subject: Needed: a new economic paradigm - FT -Stiglitz
From: "Michael Andrews" <[email-masked]>
To: "Thad Brown" <[email-masked]>, "Ronnie Mainieri" <[email-masked]>, "Chris Heinz" <[email-masked]>, "Hunter Biden" <[email-masked]>, "Eric Schwerin" <[email-masked]>, "Curt Hastings" <[email-masked]>, "Devon Archer" <[email-masked]>, "Neil Callahan" <[email-masked]>, "robert mitchell" <[email-masked]>
Date: Fri, 20 Aug 2010 06:35:43 -0400

Hey, I hope you are well. I know some of you are away as I am but if  
Stiglitz is even directionally correct our effort to form NEw Co is  
well timed since the ramifications to the existing structures will  
change and have implications to our present activities and we have an  
increased opportunity in a time of change. Michael

Needed: a new economic paradigm
By Joseph Stiglitz
Published: August 19 2010 22:18 | Last updated: August 19 2010 22:18
The blame game continues over who is responsible for the worst  
recession since the Great Depression – the financiers who did such a  
bad job of managing risk or the regulators who failed to stop them.  
But the economics profession bears more than a little culpability. It  
provided the models that gave comfort to regulators that markets could  
be self-regulated; that they were efficient and self-correcting. The  
efficient markets hypothesis – the notion that market prices fully  
revealed all the relevant information – ruled the day. Today, not only  
is our economy in a shambles but so too is the economic paradigm that  
predominated in the years before the crisis – or at least it should be.

It is hard for non-economists to understand how peculiar the  
predominant macroeconomic models were. Many assumed demand had to  
equal supply – and that meant there could be no unemployment. (Right  
now a lot of people are just enjoying an extra dose of leisure; why  
they are unhappy is a matter for psychiatry, not economics.) Many used  
“representative agent models” – all individuals were assumed to be  
identical, and this meant there could be no meaningful financial  
markets (who would be lending money to whom?). Information  
asymmetries, the cornerstone of modern economics, also had no place:  
they could arise only if individuals suffered from acute  
schizophrenia, an assumption incompatible with another of the favoured  
assumptions, full rationality.

EDITOR’S CHOICE
A philosopher should lead the dismal scientists - Aug-16

Nature and scope of economics is subject for wider debate - Aug-18

Michael Skapinker: Business has not yet found its Copernicus - Feb-15

‘Facts are meaningless’ - Oct-15

Capitalism 4.0 - Jul-18

Analysis: Seeds of its own destruction - Mar-08

Bad models lead to bad policy: central banks, for instance, focused on  
the small economic inefficiencies arising from inflation, to the  
exclusion of the far, far greater inefficiencies arising from  
dysfunctional financial markets and asset price bubbles. After all,  
their models said that financial markets were always efficient.  
Remarkably, standard macroeconomic models did not even incorporate  
adequate analyses of banks. No wonder former Federal Reserve chairman  
Alan Greenspan, in his famous mea culpa, could express his surprise  
that banks did not do a better job at risk management. The real  
surprise was his surprise: even a cursory look at the perverse  
incentives confronting banks and their managers would have predicted  
short-sighted behaviour with excessive risk-taking.

The standard models should be graded on their predictive ability – and  
especially their ability to predict in circumstances that matter.  
Increasing the accuracy of forecast in normal times (knowing whether  
the economy will grow at 2.4 per cent or 2.5 per cent) is far less  
important than knowing the risk of a major recession. In this the  
models failed miserably, and the predictions of policymakers based on  
them have, by now, totally undermined their credibility. Policymakers  
did not see the crisis coming, said its effects were contained after  
the bubble burst, and thought the consequences would be far more short- 
lived and less severe than they have been.

Fortunately, while much of the mainstream focused on these flawed  
models, numerous researchers were engaged in developing alternative  
approaches. Economic theory had already shown that many of the central  
conclusions of the standard model were not robust – that is, small  
changes in assumptions led to large changes in conclusions. Even small  
information asymmetries, or imperfections in risk markets, meant that  
markets were not efficient. Celebrated results, such as Adam Smith’s  
invisible hand, did not hold; the invisible hand was invisible because  
it was not there. Few today would argue that bank managers, in their  
pursuit of their self-interest, had promoted the well-being of the  
global economy.

Monetary policy affects the economy through the availability of credit  
– and the terms on which it is made available, especially to small-  
and medium-sized enterprises. Understanding this requires us to  
analyse banks and their interaction with the shadow banking sector.  
The spread between the Treasury bill rate and lending rates can change  
markedly. With a few exceptions, most central banks paid little  
attention to systemic risk and the risks posed by credit  
interlinkages. Years before the crisis, a few researchers focused on  
these issues, including the possibility of the bankruptcy cascades  
that were to play out in such an important way in the crisis. This is  
an example of the importance of modelling carefully complex  
interactions among economic agents (households, companies, banks) –  
interactions that cannot be studied in models in which everyone is  
assumed to be the same. Even the sacrosanct assumption of rationality  
has been attacked: there are systemic deviations from rationality and  
consequences for macroeconomic behaviour that need to be explored.

Changing paradigms is not easy. Too many have invested too much in the  
wrong models. Like the Ptolemaic attempts to preserve earth-centric  
views of the universe, there will be heroic efforts to add  
complexities and refinements to the standard paradigm. The resulting  
models will be an improvement and policies based on them may do  
better, but they too are likely to fail. Nothing less than a paradigm  
shift will do.

But a new paradigm, I believe, is within our grasp: the intellectual  
building blocks are there and the Institute for New Economic Thinking  
is providing a framework for bringing the diverse group of scholars  
striving to create this new paradigm together. What is at stake, of  
course, is more than just the credibility of the economics profession  
or that of the policymakers who rely on their ideas: it is the  
stability and prosperity of our economies.

The writer, recipient of the 2001 Nobel Memorial Prize in economics,  
is University Professor at Columbia University. He served as chairman  
of President Bill Clinton’s Council of Economic Advisers and as chief  
economist of the World Bank. He is on the Advisory Board of INET