FIRST PART.

EMILIANO COTELO:
Professor Stliglitz, you have recently been awarded, jointly with George Akerlof and Michael Spence, the Nobel Prize for your contributions to the understanding of the importance of information asymmetries in the market economy. Could you briefly explain those contributions?

JOSEPH STIGLITZ:
The idea for our work was that economists use theories, models that assume the information was perfect and the hope was that even if the information is slightly imperfect the results that you got by analyzing perfect information models provided a good description of what the actual economy was like. We all knew that there were all kinds of imperfections of information. What we did was to show that that hope was not true, that even a little bit of imperfection of information would have very large consequences. The particular kind of information imperfection that was noted by the Nobel Prize Committee had to do with asymmetry of information which is a very simple idea. That the different participants in the market note different things. That for instance, the seller of a used car knows whether his car has a problem. He knows more about the car than the buyer. The borrower in the capital market knows a little bit more about his likelihood of repaying than the lender. The guy buying insurance in the market knows whether he smokes a lot, whether he lives a bad life that makes it more likely that he will die young, or knows his overall health condition. So there's a lot of these asymmetries, they are pervasive in employer-employee relations and that a great deal of economic activity is affected by these asymmetries. That in a multiplicity of ways trying to, on the one hand, extract information to ask somebody whether he is a good insurance prospect or his car is good, he'll tell you of course it's good. So you have to be cleverer in extracting the information. At the same time in other situations people do try to create asymmetries of information because that can give them more bargaining power in the market so these asymmetries of information are a key aspect of economic behavior.

PABLO ROSSELLI:
Professor Stiglitz, in several articles and conferences you have insisted on the importance of information asymmetries in the functioning of the financial markets. Could you briefly explain, in layman's, terms the main theoretical issues in this respect? For example, the temptation that banks may face to engage in risky lending or imprudent lending.

JS: One of the most importance consequences of the ideas that we put forward on asymmetric information is that it could lead to markets not clearing. The basic idea in Economics is that demand equals supply, historically. This was a problem because it left unexplained important phenomenon like unemployment. Everybody knows that unemployment exists and yet the traditional theories that have prevailed in Economics is that unemployment didn't exist. Well, in the capital market the corresponding phenomenon is credit rationing. Everybody knows that you can't go down to the bank and borrow as much as you want, demand does not equal supply. The question is why. Well, what we emphasized was the fact that, let's assume that demand for credit equals supply. Old-fashioned theory would say: well, you go down to the bank and say, I will offer you more than somebody else. And the bank starts thinking: well, why might he be willing to offer me more? Well, one of the reasons why he might be willing to offer me more is that he doesn't plan to repay. If you are not going to repay the loan, then of course, what interest rates you promise is of not much interest, so the bank knows that on average those who are willing to pay very high interest rates are either undertaking very risky actions and are unlikely to repay for one reason or another and so it recognizes that it is better to keep interest rates lower than they might otherwise have been, even if it means there is excess demand for capital.

PR: Another problem this information asymmetry raises is in regard to the imprudent lending that the banks may engage in, and the need of the banking regulator to take into account these sorts of problems. So, what kind of recommendations arise from your contributions?.

JS: The issue of imprudent lending is characterized by a cartoon that appeared at the time that Andy Weiss and I were writing our paper. It was a period in which interest rates in the United States had risen to very high levels and it showed a banker leaning over his desk and saying to the potential borrower, "what kind of banker would lend to somebody that was willing to borrow at the high rates of interest that we charge?" And that illustrates the fact that quite often the loans that have very high interest rates are precisely the loans that are very risky. What is of particular concern for public policy is that when banks make very risky loans and a number of the loans go into default, Government often winds up picking up the pieces. This happened in the United States in the Saving & Loans (S&L) crisis, where again the banks made a lot of high interest loans but very risky loans. They didn't work out and there was what we call the "S&L" debacle, and the bail out that cost the American taxpayers hundreds of billion of dollars. The implication of that is that today we recognize the importance of banking regulations and that these banking regulations need to take on a variety of forms. And again, even the banks ... the whole approach to banking regulations has been affected by the theory of asymmetric information, recognizing that the bank regulator often knows less information than the bank being regulated. So there are a series of problems of asymmetric information. The bank may know less about the loan than the borrower, but the regulator may know less about what is going on than the bank. And the theories that we have developed are aimed at trying to enhance the design of bank regulations in the presence of these kinds of asymmetries of information. For instance, one of the implications is that it may be desirable if you can enforce it to restrict the interest rates that are charged on loans. That in the old-fashioned theory, restricting interest rates charged is interference with the market. In the new theories this may actually be a desirable thing to do because in fact the highest interest rate loans are the riskiest loans and some of the costs of that risk is borne by the public taxpayer indirectly in its higher probability of default.

EC: Uruguayan banking system is highly dollarized. More than 70% of bank deposits and loans are nominated in U.S. dollars, thus limiting the Government's ability to use the exchange rate policy in order to offset negative external shocks. In the present situation, if the domestic currency depreciates in real terms, several households will finding it difficult to service their debts in U.S. dollars. So... is there any specific role for the regulation policy in order to reverse the high dollarization of the Uruguayan banking system?

JS: I think there is increasing recognition around the world that excessive dollarization can impose constraints on the conduct of macroeconomic policy and reduce the freedom to manage the economy in a very important way. I have had conversations in many different countries on precisely that issue. The process of de-dollarization is a very slow process, it can't be done overnight. I think one has to recognize that there is a social cost to excessive dollarization, precisely for the reasons you stated. And I think that what countries have to begin to do is to explore alternative ways of de-dollarizing gradually. Probably the most important kinds of vehicles for doing that have to do with a combination of taxation, information and regulation. That is to say on the information side, trying to explain to households the advantages and disadvantages of dollarization. The dollarization may be a good thing under certain circumstances but in a world in which exchange rates change and you borrow in dollars you may be facing a severe problem. Taxes are another example where you can encourage through better tax treatments, save interest on local denominated loans, more tax deductibility than you do on dollar denominated loans, encourage people to not be dollarized and this is the recommendation that people began to discuss very heavily in the East Asia crisis where excessive borrowing in dollars was a very serious problem. And finally bank regulations themselves can often be important in trying to avoid a mismatch between assets and liabilities that it can't take away inflexibility. Malaysia used the bank regulatory approach very successfully in trying to manage the exposure of its corporations and households to a mismanaged assets and liabilities structure.

PR: Should you also include incentives that, for instance, could work through a deposit insurance system with risk premiums that take into account the degree of dollarization of each institution?

JS: Very much so. I think when I said regulation I actually had in mind a broader set of both regulations and incentives for the banking system. And so, regulations are often easier to implement but I firmly believed that more broadly one should use incentives for instance as you suggested: on the interest rates, on the premium charged on the deposit insurance, another one is that most countries today have what is called risk based capital adequacy requirements where the amount of capital that they require to keep against the risk they face are suggested on the basis of a judgement of those risks. That judgment could be that greater capital be required for those that have greater exposures, so that's another vehicle.

PR: So. could it also work on provisions for doubtful accounts?

JS: Exactly. Provisioning requirements can also be adjusted to reflect the differences in risk, I mean these are not meant to be punitive, these are really saying in today's world we have to adjust for the risks as we see it. There is a large risk associated with the exchange rate instability. Exchange rate instability is not a problem ... wasn't invented in Uruguay, exchange rate risk occurs ... when I was at the Council of Economic Advisors (with president Clinton) we saw the value of the dollar and the yen go from 106 to 80 up to 130, so this is not an attribute of just small countries and you say well, we didn't manage it well, even when you have good economic management, you face these risks. With responsible management you can't solve these risks but at least you let people know what the risks are, and at least you make adequate precautions against those risks. That's where economic policy today has to be aimed at recognizing the risk and figuring out how we can manage it.

SECOND PART

EC: We invite you to talk now about more practical questions.
You´ve strongly criticized the role of the U.S. Treasury Department and the International Monetary Fund (IMF) in handling both the financial crisis in East Asia and the transition process in Russia. Could you describe the major mistakes made in these cases?

JS: In the case of East Asia it was ... to over simplify. But to get to the core of the problem, the countries were going into a crisis. The crisis meant that investment was plummeting, consumption was plummeting, we had the data that made it very clear that these countries were going into recession, a very deep recession. The issue was what to do. Standard economics taught everywhere in the world says for a country going into recession try to have expansionary monetary and fiscal policy. And the role of IMF established when Keynes is the intellectual godfather of the IMF was to provide liquidity, money for countries to maintain expansionary fiscal policies in the light of that kind of major economic downturn. So that was what I thought was both the policy that the countries ought to pursue, and the role of the IMF. If they had done that, the economies' growth would have been slowed down but would have maintained themselves, confidence would have been restored, capital would have come back, and growth would have resumed. Instead, what did they do? They pushed contractionary monetary and fiscal policy. Huge conditionality on these countries that had never had a problem. These countries, you have to remember were not like Latin America, they have fiscal surpluses in normal times. They had tight monetary policies, inflation had been brought down in Korea from 5.5 to 4%. So they had good macroeconomic management and then they squeezed these countries, that turned what would have been a downturn into a recession, a deep recession, into a depression. And then to make matters worse, they had a problem of weak financial institutions, they shut down sixteen banks in Indonesia and then said we are going to shut down more. But your deposits won't be guaranteed. So they engineered a bank run, causing devastation to the financial system. Then, when unemployment was soaring, real wages were falling, they announced: well, we have billions and billions to bail out American, Western creditors and the banks but, by the way, we don't have any money to maintain food subsidies, kerosene subsidies, for the very poor. We know enough now that about the interaction of economic and social forces to know that if you do these kinds of things in a society that has had problems of ethnic conflicts you are going to get, you have a high probability of having social and political turmoil. And that's precisely what happened, and when you have that you didn't attract more people into the country, you didn't attract investment into the country, capital fled, making the downturn even worse, far worse.

EC: How do you explain those mistakes in IMF policies?

JS: I think it was a reliance on simplistic economic models, the kinds of models that they used for instance, did not incorporate the kinds of research that has gone on in the past twenty years focusing for instance on information problems, credit rationing problems, bankruptcy problems, they simply ignored all these kind of concerns, and work that actually George Akerlof and I had done, trying to bring in the social dimension into economics. You asked the question about what happened in Russia. I don't think the full nature of the failure has been fully taken on board. Remember that these countries had communist Governments, economies. Everybody recognized how bad communism was. Central planning, distorted prices, no incentives, no private property, it should have been very clear with all those problems, you switch to a market economy output should have gone up. Should have not only gone up a little bit, it should have soared. What happened? Output actually in Russia fell by about 40%. Poverty went from about 2% to over 40%. More than one out of 2 children live in poverty today. And it was because again there was excessive reliance on bad economic models, ideology, and I think a certain amount of special interests focusing on the wrong issues: concerns about creditors, the mixture of bad economics, ideology, and special interests is one that can really cause problems. The consequence was that for instance privatization, which when well done can be a very important force for the good, became a force for the downturn. Rather than leading to wealth creation, it led to asset stripping. The open capital market meant that they took their capital and invested it in New York and Cyprus and their own economy didn't grow but went into a deep recession, depression.

PR: And do you think any of these approaches in the IMF have changed in the last times?

JS: I think there is a much greater awareness of the importance of poverty, a much more awareness that in East Asia they made some very big mistakes. However, there has not been a fundamental re-examination of the models that they've used, they said, they agree now that they were excessively contractionary, but I've never seen an analysis of why they made the wrong prescription. They know the prescription is wrong, but they haven't gone back to the question of where were our models wrong. What did we do wrong in our analysis? Why did we come to the wrong conclusion, and why did we so often come to the wrong conclusion? A deeper analysis has not occurred. There has been more openness, more transparency, but still it doesn't conform to the principles of transparency in democratic societies.

EC: What kind of institutional arrangements should be implemented in order to make IMF governance more democratic?

JS: Well, in the United Nations, five countries have a veto power, and many people believe that that is not consistent with modern democracy. India does not have a veto power. France does.
In IMF one country has the veto power. And the countries are represented not by broad based delegations... but by central banks and finance ministers, so the IMF policies affect not just finance markets but they affect labor, they affect everybody in society, and yet those affected parties have no voice. It's going to be very difficult to change the underlying governing structure. But transparency is something that can be changed. In the United States and in many other countries today there is something called the Freedom of Information Acts, the rights of people to know what is going on. The IMF does not have that kind of principle of freedom of information. It basically does not conform today to the standards of openness and transparency that have become an essential part of democratic institutions. And I think those changes can be done, and that can be done easily.

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Research: Roberto Porzecanski y Pablo Rosselli.
Transcription: Silvana Zanetti y Carl Webster.
Edition: Emiliano Cotelo y Pablo Rosselli.