NBER WORKING PAPER SERIESSERIES INFORMATIONAL IMPERFECTIONSON ThEThE CAPITAL MARKET ANDAND MACRO—ECONOMIC FLUCTUATIONSFLUCTUPT IONS Bruce Greenwald Joseph E. Stiglitz AndrewWeiss Working Paper No. 13351335 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts AvenueAvenue Cambridge, MA 02138 April 198)419814 The research reported here is part ofof thethe NBER1sNBER1s researchresearch programprogram in Taxation. AnyAny opinionsopinions expressedexpressed areare those of the authors andand not those of the National Bureau of EconomicEconomic Research.Research. NBER Working Paper ##1335 April 1984 Informational Imperfections onon thethe Capital Market and Macro—Economic FluctuationsFluctuations ABSTRACT This paper describes the role that informational imperfections in capital markets areare likelylikely toto playplay inin businessbusiness cycles. cycles. It thenthen developesdevelopes 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 ef- fective cost of capital in response toto relativelyrelatively smallsmall demanddemand shocks.shocks. The model also derives an expression forfor thethe costcost ofof equityequity capitalcapital inin thethe presence of adverse selection and provides informational explanations for several widely observed macro—economic phenomena.phenomena. Bruce Greenwald Joseph E. Stiglitz Andrew Weiss Harvard Business School Harvard Business School Princeton University Columbia University Boston, MAMA 0216302163 Princeton, NJNJ 0854408544 New York, NYNY 1002410024 INFORMATIONALINFORMATIONAL IMPERFECTIONS IMPERFECTIONSIN IN THE CAPITALCAPITALMARKET ANDMACRO—ECONOMIC FLUCTUATIONS Traditional neoclassical theorytheory has one clear,clear, unambiguous,unambiguous, and and verif verifi- i— able prediction:prediction: allall factors factors which which havehave a positivepositive priceprice areare fullyfully utilized. In recent years, there have been several responses to the apparent inconsistency between the predictions ofof neoclassicalneoclassical theorytheory andand whatwhat hashas Inin factfact beenbeen observed.observed. The firstfirst isis toto denydeny thethe empirical empirical observations: observations: thethe 25%25% ofof thethe populationpopulation thatthat were unemployed in in the the Great Great Depression, Depression, let let alone thethe 10%10% ofof the populationpopulation thatthat were unemployed inin thethe Reagan Reagan Recession Recession were were not not involuntarily involuntarily unemployed. unemployed. ThisThis seems to us, at best, semanticsemantic quibbling,quibbling, andand wewe shallshall havehave nothingnothing furtherfurther toto saysay here concerning thatthat view.view. TheThe secondsecond is to argue, without muchmuch justification,justification, that there are two regimes; traditional neoclassical theory applies in "normal times."tiuies." ItIt seemsseems moremore plausibleplausible toto usus thatthat thethe marketmarket failures represented byby thethe Great Depression areare alwaysalways presentpresent inin thethe economy,economy, butbut difficultdifficult toto detect;detect; itit isis only when they they reach reach the the proportionsproportions thatthat theythey dodo periodicallyperiodically that that we we cancan nono longer ignore them. A third approach is to modify the standardstandard theory,theory, toto assumeassume thatthat wageswages and pricesprices areare fixed.fixed. ThisThis approachapproach hashas rightfullyrightfully been criticized both for its ad hocery and its inconsistency——whyinconsistency——why shouldshould rationalrational profitprofit maximizingmaximizing firms,firms, obeying all of the other neoclassical assumptions, not cut their prices in the face of excess demand. This paperpaper isis partpart ofof anan attemptattempt toto developdevelopa a consistent consistent set set of ofmicro— micro— foundations for macro—economics,macro—economics, based based on on imperfect imperfect information. information. WeWe focusfocus herehere onon the capitalcapital market.market. KeynesKeynes arguedargued thatthat thethe sharpsharp drop in investment and the failure of the interest raterate toto fallfall sufficientlysufficiently toto restorerestore investmentinvestment toto aa normal level was aa centralcentral partpart ofof thethe descriptiondescription ofof anyany businessbusiness cycle. cycle. Keynes'Keynes' analysis ofof investmentinvestment was,was, however,however, basically basically a aneoclassical neoclassical analysis: analysis: itit waswas —2— the failure of the real interest raterate (the(the long—termlong—term bondbond rate)rate) toto fallfall suffi-suffi- ciently that was thethe sourcesource ofof thethe problem.problem. Three aspectsaspects ofof thisthis analysisanalysis havehave alwaysalways been been troubling: troubling: first, Keynes' explanation of the failure of real interest rates to fall, the liquidity trap, is notnot persuasive.persuasive. Second,Second, surveyssurveys suggest that firms' investmentinvestment behaviorbehavior is not particularly sensitivesensitive toto the the interest interest rate rate that that they they pay. pay.Third, Third, itit hashas always seemed difficult to account forfor thethe magnitudemagnitude ofof thethe fluctuationsfluctuations inin investment in terms of the observed magnitudesmagnitudes ofof variationsvariations inin realreal interestinterest rates, outputs, wages, and prices, unlessunless firmsfirms areare veryvery riskrisk averse;averse; andand itit Isis hard to reconcile highhigh degreesdegrees ofof riskrisk aversionaversion onon thethe partpart ofof firmsfirms withwith well—functioning (neoclassical) capital markets.markets. This paper is based on the hypothesis thatthat Keynes'Keynes' judgmentjudgment concerningconcerning that the importance ofof fluctuationsfluctuations inin investmentinvestment isis correct,correct, butbut thatthat hehe Incor-Incor- rectly analyzedanalyzed thethe determinantsdeterminants ofof investment investment behavior. behavior. WeWe argueargue that:that: 1. ManyMany firmsfirms faceface creditcredit constraints;constraints; thus it is the availabilityavailability ofof credit, not the price whichwhich theythey havehave toto pay,pay, whichwhich restrictsrestricts theirtheir investment,investment, oror when it is working capital which is curtailed, which limits their production. 2. FirmsFirms thatthat areare notnot creditcredit constrainedconstrained maymay stillstill face an increase inin the effective cost of capital, which induces them to reduce their investment. (The increase in thethe effectiveeffective costcost ofof capitalcapital hashas furtherfurther effects,effects, e.g.,e.g., onon thethe pricing decisions of firms.) I. TheThe DebtDebt Market The main informational problemproblem facingfacing banksbanks isis thatthat theythey dodo notnot knowknow howhow the money theythey lendlend isis beingbeing invested. invested. Stiglitz—Weiss (1981,1983)(1981,1983) showedshowed thatthat anan increase in the interest raterate chargedcharged borrowersborrowers will,will, inin general,general, increaseincrease thethe average riskinessriskiness ofof thethe projects projects a abank bank is is financing. financing. ThisThis isis eithereither becausebecause borrowers switch toto riskierriskier projectsprojects oror becausebecause safersafer projectsprojects becomebecome relativelyrelatively —3— less attractive andand soso investorsinvestors withwith safe safe projects projects do do not not apply apply for for loans. loans. TheThe effect on the riskiness of loans may outweighoutweigh thethe directdirect gaingain toto thethe bankbank fromfrom increasing itsits interestinterest rate. rate. Thus, the bank's profitprofit maymay bebe maximizedmaximized atat an interest rate at which there is an excessexcess demanddemand forfor loanableloanable funds.funds. This kind of phenomenon (an interior price maximum andand rationing,rationing, whichwhich may also occur in thethe laborlabor market)market) helpshelps toto explainexplain businessbusiness cyclescycles inin threethree ways. First, and and mostmost obviously, it it providesprovides aa rationalerationale for thethe persistencepersistence of non—market—clearing. Second,Second, it may may accountaccount forfor variationsvariations in a firm's cost ofof capital whichwhich areare unrelatedunrelated toto observedobserved variations variations in in interest interest rates. rates. TheThe likeli-likeli- hood and severity ofof creditcredit rationingrationing maymay wellwell increaseincrease inin aa recessionrecession withoutwithout necessarily anyany concurrentconcurrent changechange in in interest interest rates. rates. AnAn increaseincrease inin creditcredit rationing might be expected both because ofof greatergreater uncertaintyuncertainty concerningconcerning thethe prospects of firms and an increase in the dead—weight loss associated with bank- ruptcy. Third,Third, information—basedinformation—based rationingrationing models can explainexplain howhow stabilizationstabilization policy isis likelylikely toto work.work. ForFor example,example, monetary policiespolicies whichwhich seekseek toto increaseincrease investment byby loweringlowering interestinterest ratesrates will will not not have have the the desired desired effect: effect: therethere isis no shortage ofof willingwilling borrowers.borrowers. However, policies thatthat IncreaseIncrease thethe avail-avail- ability of loanableloanable fundsfunds willwill increaseincrease investment,investment,