Posted by: Dirk | August 30, 2010

Sound Finance and Sustainable Development in America

Joseph Stiglitz in a speech to the Asia Development Forum said 11 years ago:

We should remember, too, that the great merit of a market economy is that dispersed information is aggregated through prices and the incentives they create for behavior, without the need for any centralized collection of information or planning. There is a certain irony about praising a market economy for this decentralization of information, and at the same time complaining about the lack of aggregate data necessary to assess systemic risks.

Moreover, we should not be under the illusion that improved data is sufficient for financial markets to function well. In East Asia much of the important information was available, but it had not been integrated into the assessment of the market. Furthermore, it is impossible to eliminate all uncertainty and asymmetries of information. Entrepreneurs will always know more about their investments than will the banks that lend to them; and managers will always know more about their actions than shareholders will. Without the correct incentives, even perfect aggregate information would not be sufficient for the efficient, or stable, functioning of markets.

This is a point that is often overlooked these days. Stress tests not withstanding, investors with short-term bonus payments might not care about the long-run consequences. Access to information only brings us so far. What is needed is the right kind of incentive system which awards sustainable investment and punishes short-run risky activities that are bound to fail. Of course, the trick will be to distinguish the two.

Another prescient extract from that speech is this part:

One of our objectives should be to try to influence the pattern of capital flows. Procyclicality is another undesirable feature of the international capital flows. Countries seem to get the most private capital when they are growing strongly and need it least, and have a relatively harder time accessing capital in hard times when they need it most. As a result capital flows do relatively little to smooth the business cycle, and may even amplify it. Accomplishing this objective, however, may be very difficult.

Well, once more we still haven’t gone above what has been said by Stiglitz in 1999 (actually, “The Great Moderation” replaced this criticism). Capital flows from poor to rich countries should not make sense in a global economy, at least not according to orthodox theory. Capital is supposed to be scarce, and it should be going where returns are highest – which is unlikely to be the place where it is relatively abundant.

This is an issue that needs more research. I would propose to make a distinction between capital as physical goods for investment and capital as (foreign) debt a.k.a. claims to income in the future. That should bring some clarity.

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