Deflation, Globalization and The New Paradigm of Monetary Economics

Joseph E. StiglitzMinistry of Finance

April 16, 2003

Tokyo

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Problems with traditional keynesian Problems with traditional keynesian macroeconomicsmacroeconomics• Not based on micro-foundations

In 70s, concern was that behavior could not be deduced from hypotheses of rational actors maximizing utility or profits

• Focused on problems arising from price rigidities In 70s, problem was inflation Today, many countries are worried about deflation Even in 30s, assumption of price and wage rigidity

not convincing

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Monetary theory based on transactions demand for money especially problematic

• Money not needed for most transactions (credit used for most)• Most money is interest bearing

Opportunity cost of ‘money’ (difference between interest rate on CMA accounts and T-bills) simply determined by transactions cost, unrelated to economic activity

• Most transactions trades in assets and not directly related to income generation Relationship between two not stable over business cycle

• Seeming instability of velocity –Led to end of monetarism in most countries.

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Empirical puzzles and problems (I)

• Relative stability of real interest rates

• Little evidence of effect of real interest rates on investment (US)

• Considerable evidence of effects on nominal interest rates

• Investment equations in which cash flow and net worth appear significant

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Empirical puzzles and problems (II)

• Host of anomalies and questions Inventory – pro-cyclical rather than anti-cyclical Exports often do not seem to increase as much as

one would have expected after large devaluations (East Asia Crisis)

Movements of real product and consumption wages over business cycle

• Why some shocks get amplified –standard theory predicts economy should dampen shocks

• Why the effects of some shocks seem so persistent

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Advances in economic theoryAdvances in economic theory

• Imperfect and asymmetric information leading to imperfections in product, labor and capital markets

• Systematic ‘irrationalities’ in behavior (Kahnemann and Tversky)

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Two solutionsTwo solutions

• New classical, real business cycle theory

• New keynesian theories

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Why new classical and real business Why new classical and real business cycle theories failed? (I)cycle theories failed? (I)

• Assumed away problem of unemployment• More broadly, ignored mounting theory and evidence

concerning imperfect and asymmetric information and irrationalities Cannot have asymmetric information with

representative agent Stock market behavior exhibits irrational exuberance

and pessimism, herd behavior, etc (Shiller and others)

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Why new classical and real business Why new classical and real business cycle theories failed? (II)cycle theories failed? (II)

Host of corporate, accounting, and banking scandals in US and Europe related to imperfect information, significant macroeconomic effects

Most of results had nothing to do with rational expectations, but depended on perfect market assumptions

o With market imperfections, rational expectations may increase efficacy of government policy, not diminish it (Neary-Stiglitz)

• Rested on implausible assumptions Major source of disturbances are technology shocks Economy randomly becomes less efficient!

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Two branches of new ‘keynesian’ Two branches of new ‘keynesian’ economicseconomics

• Rigid wages and prices But wages and prices not rigid And menu cost theories of explanation of price

rigidities unpersuasive Efficiency wage theories (Shapiro-Stiglitz) do help

explain real rigidities, but not nominal rigidities• Fisher debt deflation theories

Developed by Greenwald and Stiglitz, based on asymmetric information and asymmetries in speeds of price adjustment

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Basic elements of theory (I)Basic elements of theory (I)

• Credit rationing and equity rationing (imperfections of capital markets limit use of equity markets in raising new funds) mean that: Firms act in a risk averse way Firm balance sheets matter –for production, investment,

employment, all decision Firm cash flows matter

• Household and government balance sheets and cash flow also matter

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Basic elements of theory (II)Basic elements of theory (II)

• Focuses on supply side as well as demand Since production is risky (and risk cannot be fully

divested) shocks to economy can affect willingness to produce, especially relevant in small open economies which in principle should face a close to horizontal demand for their products –demand should not be a problem

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Basic elements of theory (III)Basic elements of theory (III)

Supply of credit can be a critical constraint Demand and supply intertwined

o Demand shocks in one period have consequences for supply in subsequent periods

• Adverse effects on firm balance sheets lead to lower production

• Adverse effects on bank balance sheets lead to lower credit supply

• Redistributions (e.g. caused by large price changes) matter because of important non-linearities Losses to those who are worse off may lead to greater reduction

in aggregate demand than the offsetting increases by those who are better off

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New monetary paradigm (I)New monetary paradigm (I)

• Based on supply of credit (loanable funds)• Based on bank (and other) intermediation

Information problem Ascertaining credit worthiness Monitoring and enforcing loan contracts

• Banks are ‘firms’ that engage in these credit services Entails risk bearing Willingness and ability to perform service depends on

balance sheet

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New monetary paradigm (II)New monetary paradigm (II)

• Theory focuses on how (1) shocks to the economy and (2) policy (both macro-policy and regulatory policy) affect banks’ (and others’, including firms’) ability and willingness to provide credit Regulatory policy has macro-economic effects

• Theory pays special attention to bankruptcy, credit interlinkages among firms (as important as standard general equilibrium product and factor interlinkages)

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New paradigm provides a framework for thinking New paradigm provides a framework for thinking about deflation and alternative policy responsesabout deflation and alternative policy responses

• Deflation, particularly unexpected deflation, leads to real balance sheet effects which can adversely affect aggregate demand

• This is in addition to traditional real interest rate effects

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Globalization has led to some deflationary biasGlobalization has led to some deflationary bias

• Closer integration could mean ‘deflationary contagion’ –in any case, policies in other countries have major effects

• More competition• Global reserve system means that substantial global income is

simply ‘buried’ in reserves every year• Focus on inflation limits ability of expansionary monetary

policy to offset – stability pact puts deflationary bias in Europe• Sum of trade surpluss equal sum of deficits, but there is

asymmetric policy response: pressure on deficit countries to reduce deficits, with constraints on devaluation (fear of inflation) and trade policy, reducing income is only instrument in short run

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Prescription (I)Prescription (I)

• Theory suggests focus on balance sheets

• Shifting from deflation to inflation may help balance sheets –undoing damage that deflation has done in increasing real value of debt

• But some institutions with a maturity mismatch may find their balance sheet hurt –may need to have inflation or interest rate puts

• Shifting from deflation to inflation may lead to lower real interest rates

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Prescription (II)Prescription (II)

• On average, devaluation will also improve Japan’s balance sheet, given its large creditor status

• And will help to reduce deflation• This is in addition to normal trade benefits from

devaluation• Conventional way of correcting bank balance sheet

shifts problem from banks to government

But there are unconventional ways which provide as accurate a picture of the true change in government’s position as conventional method

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Specific policies: limited efficacy of Specific policies: limited efficacy of standard keynesian instruments (I)standard keynesian instruments (I)

• Income tax cuts may be ineffective, if individuals think they are temporary

• Or even if they are believed to be permanent, they may simply be used to ‘restore’ balance sheet

• Temporary consumption tax cut more likely to be effective, since the fact that it is temporary is more incredible than the claim that the income tax is permanent, and such a tax has an intertemporal substitution effect

But still may have limited effect

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Specific policies: limited efficacy of Specific policies: limited efficacy of standard keynesian instruments (II)standard keynesian instruments (II)

• Spending financed by borrowing stimulates the economy

But leaves the country in debt Worsening government’s balance sheet Could set in motion bad dynamic Households may worry about the future tax increases

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Key QuestionsKey Questions

• How to devalue, how to reverse deflation? Possible solution: Financing some of deficit spending by

printing money

• No evidence of discontinuity: moderate amount will not set off rampant inflation

• Advantage over debt finance: not treated as a liability

• Can be used to help recapitalize banks, enabling them to lend more

• Strategy was tried in Sweden in Great Depression - worked

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Important LessonImportant Lesson

• Even if this prescription works, it will not address Japan’s longer run problems

• Failure to use innovations in manufacturing elsewhere in the economy, especially in the service sector

• Unless, however, Japan does something about the continuing short run lack of aggregate demand, there is a real risk of exacerbating long run problem, as financial problems mount and investments in new technology wane.

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General conclusionsGeneral conclusions

• Need for a new macro-theory, new paradigm for monetary economics

• New theory provides better explanation of a host of phenomena

• Most importantly, new theory provides insights into how to think about a variety of policy issues