Stiglitz: 6 Lessons of the U.S. Crisis for Economic Theory & Policy
“When a bank extends a loan, it creates a deposit account, increasing the supply of money.”
Towards a New Paradigm in Monetary Economics (2003)
Banks as Social Accountants and Screening Devices for the Allocation of Credit
“The importance of credit
We would, for instance, have asked what the fundamental roles of the financial sector are, and how we can get it to perform those roles better. Clearly, one of the key roles is the allocation of capital and the provision of credit, especially to small and medium-sized enterprises, a function which it did not perform well before the crisis, and which arguably it is still not fulfilling well.
This might seem obvious. But a focus on the provision of credit has neither been at the center of policy discourse nor of the standard macro-models. We have to shift our focus from money to credit. In any balance sheet, the two sides are usually going to be very highly correlated. But that is not always the case, particularly in the context of large economic perturbations. In these, we ought to be focusing on credit. I find it remarkable the extent to which there has been an inadequate examination in standard macro models of the nature of the credit mechanism. There is, of course, a large microeconomic literature on banking and credit, but for the most part, the insights of this literature has not been taken on board in standard macro-models.
But failing to manage credit is not the only lacuna in our approach. There is also a lack of understanding of different kinds of finance. A major area in the analysis of risk in financial markets is the difference between debt and equity. And in standard macroeconomics, we have barely given this any attention. My book with Bruce Greenwald, ‘Towards a New Paradigm of Monetary Economics’ was an attempt to remedy this. [...]
Should monetary policy focus just on short term interest rates?
In monetary policy, there is a tendency to think that the central bank should only intervene in the setting of the short-term interest rate. They believe “one intervention” is better than many. Since at least 80 years ago with the work of Ramsey we know that focusing on a single instrument is not generally the best approach.
The advocates of the “single intervention” approach argue that it is best, because it least distorts the economy. Of course, the reason we have monetary policy in the first place—the reason why government acts to intervene in the economy—is that we don’t believe that markets on their own will set the right short-term interest rate. If we did, we would just let free markets determine that interest rate. The odd thing is that while just about every central banker would agree we should intervene in the determination of that price, not everyone is so convinced that we should strategically intervene in others, even though we know from the general theory of taxation and the general theory of market intervention that intervening in just one price is not optimal.
Once we shift the focus of our analysis to credit, and explicitly introduce risk into the analysis, we become aware that we need to use multiple instruments. Indeed, in general, we want to use all the instruments at our disposal. Monetary economists often draw a division between macro-prudential, micro-prudential, and conventional monetary policy instruments. In our book Towards a New Paradigm in Monetary Economics, Bruce Greenwald and I argue that this distinction is artificial. The government needs to draw upon all of these instruments, in a coordinated way. (I’ll return to this point shortly.) [...]
Price versus quantitative interventions
These theoretical insights also help us to understand why the old presumption among some economists that price interventions are preferable to quantity interventions is wrong. There are many circumstances in which quantity interventions lead to better economic performance.”
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