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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