The Lessons of the North Atlantic Crisis for Economic Theory and Policy

IMF Blog, May 3, 2013

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The Lessons of the North Atlantic Crisis for Economic Theory and Policy

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Bibliographic details

• Authors: Joseph E Stiglitz
• Published: May 3, 2013

Overview and central thesis

• Author: Joseph E. Stiglitz; Date: May 3, 2013.
• Main claim: The North Atlantic financial crisis demonstrates that economies and markets are not necessarily efficient, stable, or self-correcting, and that prevailing economic models and policy frameworks failed to anticipate or adequately address large, endogenous shocks.
• Empirical context:
  • "approximately 100 crises" during the "last 30 years" as liberalization policies became dominant.
  • A "150 year period" (a century and half) of crisis data provides a rich historical record.
• Aggregate cost mentioned: the loss in GDP between potential and actual output "is in the trillions of dollars."

Failures of models and assumptions

• Key findings:
  • Standard models focused on exogenous shocks, yet "a very large fraction of the perturbations to our economy are endogenous."
  • Models underestimated long‑run structural transformations and persistent shocks.
  • Economies are not self-correcting; post-crisis policy responses have been "tepid" and insufficient to restore full employment.
  • Many pre-crisis "improvements" increased exposure to risk; capital and financial market liberalization produced "severe costs in terms of increased risk."
  • The financial sector’s roles (allocation of capital and provision of credit) were inadequately modeled in standard macroeconomics.
• Distribution and heterogeneity:
  • Aggregate statistics (e.g., average leverage to GDP) can mask vulnerabilities; micro-level heterogeneity (e.g., many households at the bottom unable to meet debt payments) was a crucial early warning ignored by models.

Nature of the crisis and structural transformation

• Characterization:
  • The crisis is "more than just a balance sheet crisis"; it reflects a deeper "structural transformation" in North Atlantic economies from manufacturing to services and changing comparative advantages.
  • Even as deleveraging occurs, full employment is unlikely to return automatically; the pre-crisis household savings rate of "zero" is unlikely to resume, nor would that be desirable.
  • Job losses in manufacturing are largely permanent—"most of the jobs that have been lost in that sector will not be regained."
• Policy implication:
  • Slow recoveries after severe financial crises are common historically, but "the fact that things have often gone badly ... doesn't mean they must go badly."

Financial regulation, institutions, and systemic risk

• Observations:
  • Post-crisis consolidation has worsened the "too-big-to-fail" problem.
  • Distinct systemic issues noted: banks "too intertwined to fail" and banks "too correlated to fail."
  • Insufficient progress on increasing bank capital requirements; debates have neglected costs vs. benefits analysis and implications of the Modigliani‑Miller Theorem.
  • A need for a "more diversified ecology of financial institutions" to reduce excessive correlation and systemic vulnerability.
• Policy recommendations:
  • Reconsider capital account management as a tool to reduce domestic volatility from international engagements.
  • Increase emphasis on financial regulation as central to macroeconomic stability, not an afterthought.

Credit, money, and the role of the financial sector

• Analytical gaps:
  • Policy and standard macro-models under-emphasized credit provision—particularly to small and medium-sized enterprises—and the distinct economics of different forms of finance (debt vs. equity).
  • Call for shifting focus "from money to credit" and explicitly modeling credit mechanisms within macro frameworks.
• Reference: Stiglitz and Bruce Greenwald's book Towards a New Paradigm of Monetary Economics (Cambridge University Press, 2003) is cited as an attempt to remedy these shortcomings.

Stability, risk-sharing, and automatic mechanisms

• Findings:
  • The pre-crisis belief that diversification eliminates risk is "just wrong"; poorly designed risk-sharing can increase systemic risk.
  • The move from defined benefit to defined contribution pension systems may have reduced macroeconomic stability—highlighting the need for "more automatic stabilizers and fewer automatic destabilizers" across the economy.
• Policy implication:
  • Design institutions and instruments to reduce endogenous volatility and systemic amplification.

Policy frameworks, instruments, and coordination

• Critique of "single intervention" approach:
  • Monetary policy should not focus exclusively on short-term interest rates; relying on a "single instrument" is suboptimal.
  • Historical note: "at least 80 years ago" with the work of Ramsey, the limits of single-instrument policy were known.
• Instrument mix and coordination:
  • Once credit and risk are central to analysis, multiple instruments are necessary; distinctions between macro-prudential, micro-prudential, and conventional monetary policy are "artificial."
  • Governments should "draw upon all of these instruments, in a coordinated way" and ensure "close coordination between monetary and fiscal policy."
  • The Tinbergen principle (having as many instruments as objectives) is critiqued if it leads to fragmented control; coordination across instruments and objectives is essential to improve growth, stability, and distribution.
• Price vs. quantity interventions:
  • The presumption that price interventions are always superior to quantity interventions is incorrect; "there are many circumstances in which quantity interventions lead to better economic performance."

Recommendations for future research and policy reform

• Revise and broaden macroeconomic models to:
  • Incorporate endogenous shocks, long-run structural change, credit mechanisms, heterogeneity, and imperfect information.
  • Analyze the tradeoffs and welfare implications of higher capital requirements with attention to Modigliani‑Miller insights.
• Institutional and regulatory reforms:
  • Strengthen financial regulation, address too-big-to-fail, too-intertwined-to-fail, and too-correlated-to-fail problems.
  • Promote a diversified financial institutional ecology.
  • Use capital account management tools to reduce volatility where appropriate.
• Policy strategy:
  • Employ multiple, coordinated instruments across monetary, macro-prudential, micro-prudential, and fiscal policy to achieve objectives on growth, stability, and distribution.
  • Expand automatic stabilizers and redesign arrangements that act as automatic destabilizers.
• Broader objective:
  • Take advantage of the crisis as "the chance to revolutionize flawed models" and escape recurring cycles of crises by identifying "really big market failures, the big macroeconomic externalities, and the best policy interventions."

Source: The Lessons of the North Atlantic Crisis for Economic Theory and Policy — Joseph E. Stiglitz, May 3, 2013.

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References

• rethinking