Bruce C. Greenwald

Externalities in Economies with Imperfect Information and Incomplete Markets

This paper presents a simple, general framework for analyzing externalities in economies with incomplete markets and imperfect information. By identifying the pecuniary effects of these externalities that net out, the paper simplifies the problem of determining when tax interventions are Pareto improving. The approach indicates that such tax interventions almost always exist and that equilibria in situations of imperfect information are rarely constrained Pareto optima. It can also lead to simple tests, based on readily observable indicators of the efficacy of particular tax policies in situations involving adverse selection, signaling, moral hazard, incomplete contingent claims markets, and queue rationing equilibria.

Informational Imperfections in the Capital Market and Macro-Economic Fluctuations

This paper describes the role that informational imperfections in capital markets are likely to play in business cycles. It then developes a simple illustrative model of the impact of adverse selection in the equity market and the way in which this may lead to large fluctuations in the effective cost of capital in response to relatively small demand shocks. The model also derives an expression for the cost of equity capital in the presence of adverse selection and provides informational explanations for several widely observed macro-economic phenomena.

Transactional Risk, Market Crashes, and the Role of Circuit Breakers

The authors develop a pair of models that illustrate how imperfections in transfunctional mechanisms can lead to a market crash. Neither market orders nor limit orders allow traders to condition their demands on the full information set needed to achieve a Walrasian outcome. When volume shocks are sufficiently large, the deviations from Walrasian prices and allocations are large also. Properly designed and implemented, circuit breakers may help to overcome some of these informational problems and thereby improve the markets ability to absorb large volume shocks.

Helping Infant Economies Grow: Foundations of Trade Policies for Developing Countries

Conventional wisdom has it that trade enhances economic efficiency and thus promotes growth. At least since Robert M. Solow’s (1957) pioneering work, however, technological progress has been recognized as the dominant factor in determining the rate of growth. This is presumably even more true for developing countries, for which the possibilities of closing the knowledge gap with advanced industrial countries offers especially large growth potential. We examine the impact of trade restrictions in economies in which technological spillovers within countries and across industries are fundamental to the process of growth (see Kenneth J. Arrow, 1962a, 1962b; Paul M. Romer, 1986; Stiglitz, 1987). Since that work, it has been clear that markets, by themselves, do not necessarily, or in general, lead to overall dynamic efficiency; and that there are often trade-offs between static inefficiencies (e.g., associated with patent protection) and long-term growth. We find, here in particular, that the dynamic benefits of broad trade restrictions may outweigh their static costs. Our analysis provides the basis of an infant economy (as opposed to an infant industry) argument for protection. This paper develops a simple two-sector model with an industrial (modern) and a traditional (craft or agricultural) sector. There are four key features to the model: (a) there are spillovers from the industrial sector to the craft sector, for which firms in the industrial sector are not compensated; (b) such spillovers are geographically based, that is, it is only productivity increases in the industrial sector in the developing countries that affect productivity increases in the traditional sector; (c) innovations are concentrated in the industrial sector; and (d) size is among the important determinants of the pace of innovation in the industrial sector. Earlier critiques of trade policies encouraging the development of the industrial sector in developing countries ignored these spillovers. They argued, in effect, that Korea would always have a comparative advantage in growing rice; therefore, it was foolish for it to try to restrict imports of industrial goods, even if by so doing productivity in the industrial goods sector was increased. It could never catch up, so the protection would have to be permanent. Year after year, the country would have been better off if it simply specialized in its own comparative advantage, growing rice. Korea could, and did, catch up, however, at least in certain areas. If catch-up is possible, then dynamic comparative advantage differs from static comparative advantage. But even if Korea’s comparative advantage remained in agriculture, industrial protection might be desirable, because by supporting it, one might have a more dynamic agricultural (traditional) sector. Trade restrictions enhance the size of the industrial sector; the benefits spill over to the rural sector; and national income grows at a possibly far faster pace. After presenting the model, we explain why the underlying hypotheses are plausible and argue that the model is broadly consistent with historical experience and empirical evidence.

Toward a Theory of Rigidities

This paper presents a theory of rigidity, or more properly inertia, in the responses of economic variables to changing environments. The theory rests on three fundamental assumptions: (1) that firms are risk averse, (2) that firms are uncertain of the impacts of changing decision variables and (3) that this uncertainty increases with the size of deviations in decision variables from appropriately defined past level. Under these circumstances an optimal portfolio of incremental decision variable adjustments exists which (a) takes variance minimizing adoptions to environmental change as a point of departure and then (b) is weighted in favor of changes in variables whose effects are less uncertain. In considering price and quantity adjustments, this implies that price and wage adjustments should largely incorporate expected inflation and, from that point, should be small relative to quantity adjustments, since in most situations the uncertainties associated with the consequences of quantity adjustment should be smaller than those associated with price adjustments.

Pareto Inefficiency of Market Economies: Search and Efficiency Wage Models

This paper shows that market economies with search and in which wages are affected by efficiency wage considerations are not constrained Pareto efficient. Wages are not set at Pareto efficient levels, nor is the level of employment (unemployment) Pareto efficient. We identify the nature of the biases and the welfare improving government interventions.

The Asymmetric Effect of Diffusion Processes: Risk Sharing and Contagion

In this paper we provide a general characterization of diffusion processes, allowing us to analyze both risk-sharing and contagion effects at the same time.We illustrate the relevance of our theory with reference to the subprime mortgage crisis and more in general to the processes of securitization and interbank linkages. We show that interdependencies in real and financial assets are beneficial from a social point of view when the economic environment is favorable and detrimental when the economic environment deteriorates. In the latter case, private incentives are such that too many linkages are formed, with respect to what is socially desirable. The risk of contagion increases the volatility of the outcome and thus reduces the ability of the financial networks to provide risk-sharing.Our analysis suggests that a likely major explanation of the subprime mortgage crisis is the process of securitization itself, in addition to the absence of transparency about the characteristics of the underlying assets that the multiple layers of financial intermediation fostered, as commonly claimed.This may call for a different emphasis on the role of public intervention. While a goal to stabilize the economy in good times should be to disrupt the channels that bring contagion, that is a positive correlation in the returns, in a period of worsening economic conditions our analysis suggests regulatory intervention aimed at disconnecting the economy at crucial nodes. Moreover, we show that policy interventions should be aimed at rescuing institutions, but not their managers. Diminishing the cost of default actually increases the inefficiency due to the divergence between the social and the individual optimum.

Industrial Policies, the Creation of a Learning Society, and Economic Development

Industrial policies — meaning policies by which governments attempt to shape the sectoral allocation of the economy - are back in fashion, and rightly so. The major insight of welfare economics of the past fifty years is that markets by themselves in general do not result in (constrained) Paretoefficient outcomes (Greenwald and Stiglitz, 1986).

A Modest Proposal for International Monetary Reform

An ideal system of international payments should be characterized by stability and balance: stability in exchange rates and the absence of sudden crises, and balance in the sense that individual national economies should suffer neither from the deflationary effects of chronic external deficits nor the distorting consequences of chronic external surpluses. Both requirements are essential to the efficient international movement of capital. Yet neither requirement appears to have been met by the current dollar-based reserve currency system. Recurrent crises in Asia, Latin America, and Eastern Europe, and chronic and growing US payments deficits (with their associated deflationary impact) are longstanding characteristics of the current system. This chapter argues that the problems just described are fundamental aspects of the present system and that, without reform, they will continue to plague the global economy. However, a simple set of institutional reforms would go a long way toward alleviating these difficulties. In order to understand the need for and nature of these reforms, we begin by analyzing the dynamics of the current system using a simple global macroeconomics framework. Within this context, we examine a number of proposed explanations for current imbalances and ultimately focus on a small number of potentially responsible factors. They bear a striking similarity to those which Keynes cited in connection with the failure of the pre-Bretton Woods system. The chapter then lays out reforms designed to alleviate these problems. Finally, it ends with a broader analysis of the costs and benefits of such a reformed system. Issues of reform of the global reserve system have achieved increasing attention, especially since the UN Commission on the Reform of the Global Monetary and Financial System, chaired by Stiglitz, suggested that this was the most important item on the longer-term agenda for ensuring a more stable global financial system. China’s Central Bank governor has added his voice to those suggesting a need for a reform. We argue that a key explanation for the massive global imbalances that prevailed in the years prior to the crisis—andwhose disorderly unwinding has been a

Sectoral Imbalances and Long-run Crises

There has been a widespread presumption that the current economic crisis is a financial crisis, caused by the bursting of a credit bubble. Unjustified optimism about asset prices and associated risks (primarily in housing but also in financial industry equities and even in equities generally), accommodated by lax regulation, careless private lending and loose monetary policies, led to unsustainable levels of household and financial sector leverage. The inevitable collapse of the underlying asset prices then caused widespread bankruptcies, foreclosures, and impaired balance sheets among households, firms, and financial institutions. Combined with consequent large increases in the incremental risks of lending and investing, these balance sheet effects induced large declines in household spending, firm output and investment, and bank lending.1