A Critique of McKinnon-Shaw Hypothesis; Stiqlitz and Weiss Model (EN)

In the previous article we talked about financial liberalization; the McKinnon-Shaw hypothesis. In reality it didn’t work, it didn’t deliver what it promised. Basically liberalized market were gone to failure. And people wanted to know why markets failed even when they were liberalized. Stiqlitz and Weiss developed a model to give an answer but this model actually came from Akerloff(1971).

In 1971, Akerloff wrote an article titled “Markets for Lemons”. Using Nash Equilibrium, Akerloff explains a lemon market and its working. Lemons means second hand car here. Yet, the article was rejected because people didn’t understand what he was talking about, it was too mathematical.

In the article, he argues that in the presence of asymmetric information, markets tend to fail. Seller of a lemon knows what is wrong with the car. He knows every problem of the care but he will try to hide those problems. The seller will act in a morally hazardous way. He will cheat by hiding the problems basically. Yet the buyer not knowing what is wrong with the car will agree the price of the car that is above worth of the car. Basically price between two is not market cleaning price. Because of sellers hazardous behavior, markets will fail. So that individual behavior will determine market outcome. Until 1980’s people didn’t care about the article. Stiqlitz and Weiss took up his idea and used in 1981’s article.

Banks use interest rate as screening device. By looking at interest rate, they determine whether they should continue lending or not. By looking at the interest rate, they actually look at the riskiness of borrower. Banks are assuming that if there is asymmetric information between lenders and borrowers, they may end up with a cost. Acquiring information is a costly business. Banks will acquire information about their borrowers. If they feel that their borrowers are cheaters that they are going to hide the problems of their project. Then lenders will stop lending to those borrowers. So banks are basically in the business of monitory.

Assumptions of the model:

Ø Banks are monitors: They monitor their customers.

Ø Banks are quantity setters: Banks set what amount to lend

Ø Banks are price setters: Banks set the price that point onwards they are going to lend out. Banks by themselves determine prices, interest rates. In a free market, this is possible. No one can force banks to lend more or set prices higher or lower.

Ø Banks are information processors: Information is used as an analitical organizing category not an economic one. It comes from somewhere else. Information is introduced to the model as a non-economic factor. But using that non-economic factor, they want to explain an economic matter. So information is exogenous here.

Looking at this bank behavior, bankers’ expected returns increase as their risk perception increases which measured in terms of interest rate. If their risk perception goes beyond r*, then they think that they are going to be cheated and they will be lending to immoral borrowers. Those borrowers will take the money and run away. So they stop lending out. Now, these borrowers who are willing to pay beyond r*, they will be known within the market. Company A applies for a credit to a bank and the bank refuses that company, then company A will go to another bank and that another bank will know that previous bank refused to credit that company. Then the company will be more risky in the market. It will be much more difficult for them to borrow. And they will be willing to pay high interest rate because the perception of the company has been risky. It needs to compensate that risk by giving high interest rate so that it compensates for expected returns of bankers. This is how markets work.

So using this kind of idea, Stiqlitz and Weiss set proves why markers failed. Expected returns are determining the amount of credit supplied into the market. Demand for credit will go down as interest rate increases. Credits become cheaper, demand for credit goes up. At the equilibrium level of interest rate, banks are no longer supplying to fill the demand. By looking at the individual banks behavior, Stiqlitz and Weiss come up with a conclusion that even markets are free, they may still fail because equilibrium rate is beyond where banks’ willing rate of interest to clear the market. So what happens with the banks -because markets failed in that sense- what they do is that they start cherrypicking their customers and that is called adverse selection. Banks are choosing customers that are adversely selected because banks know them better. And the ones who are probably have better project are not given credit. So as a result of it, markets fail.

When this model published, it answered why McKinnon-Shaw collapsed. The reason why it collapsed is not the model itself, it was the information that it’s playing its role in the market. Availability of information when it’s asymmetric to the borrowers and lenders, it causes markets to fail. The model was not wrong, the people who aren’t behaving as the requirements of the model were wrong. Because people’s information about the working of the market is asymmetric. But if we increase transparency, if we create informational rich environment then markets will clear.

So a reform is needed to market based models and that reform should enrich informational environment. We need to bring the government back in for markets to work but not in the economic area. Government should come back in to enrich informational environment if there is no asymmetric information between borrowers and lenders, then credit markets will clear. Interest rate will reflect fundamentals in credit markets. If that happens for credit market then any other market will be the same.

Set of reforms are brought in:

Ø Privatization: Take the government off the economic area

Ø Transparency: To achieve this, we have to pass accounting standards and those accounting standards are international standards. And they should be implemented by using digital environment. Companies must report their audit account on a regular basis. Countries must develop their stock market because stock markets help homo economicus to form their portfolios, they push individuals behaving with economic logic. By doing this, they take their risk and they balance their return which lead them to formulate a price mechanism that reflects economic fundamentals in the market. The more developed stock markets, the better individual information based in circulation. Transparency requires democratisation that is allowing minorities, ethnic groups etc. to voice their demand and that will increase the transparency.

These set of reforms are aimed to create an information rich environment. Information in this case is used as an organizing principle then comes new reforms to supplement McKinnon-Shaw liberalization reform. Around these ideas a new consensus was born and it’s called “Post Washington Consensus”. We are not giving up on Washington Consensus yet but we strengthen it with Post Washington Consensus.

Southeast Asian Liberalization experience during 1960’s was an incomplete form of liberalization. Stiqlitz and his friends were economist in World Bank. They published a report in 1993. Using these ideas, they praised Southeast Asian liberalization experience. They said the reason why this experience was successful is because of incomplete form of liberalization in which the government continue to supplement markets by providing information.

As these ideas become more and more popular and more acceptable, in 1997, Southeast Asia went into deep crisis. It started in Thailand. Yet, Thailand’s economic fundamentals were quite good. There was no current account deficit. Rate of inflation was low. Economy was growing year on year. Employment rate was low. On top of that Thai baht was strong. Central bank had enough reserves. So Thai economy was okay. But all of a sudden something happened and it collapsed. And the crisis was spread around other Southeast Asian countries. For instance South Korea’s economy was also good but the crisis hit them as well. South Korea ran out of money very quickly and the IMF had to loan 55 billion $ and it was the biggest rescue operation ever. Then people started thinking what went wrong.

Thailand’s economic growth comes from their investments in construction sector. People invest in construction and those investors are coming from Japan and the U.S. But what happened is that Japanese yen was devaluated against the U.S. dollar. So Japanese investors’ money was burden in terms of the U.S. dollar. And this leverage is causing other companies to think that this market is risky. They thought that the market was going to collapse so they were better leave it. One big company leaves a market and so does everybody. Herd instinct, it’s called.

So when they look for an explanation they found it in 1929. What happened in 1929 is that J.M. Keynes looks at the behaviour of people on a beauty contest on newspaper. He follows the contest; every week, there is an election of female participants sending their merits. If they win, they get an award. And Keynes follows it and notices a very important pattern. He says in the beginning people were selecting girls as their favours and if they find the girl, they get money out of it. It’s like gambling. But then he notices that people are not looking at the girls’ merits anymore but they are looking for the interests of the jury. This is how people behave and out of this, he develops a stock market behaviour based on a beauty contest. And it is highly mathematical resolution for a beauty contest.

In 1997, when SEA crisis happened, people dig this out and explain SEA crisis on these bases. People are not looking at the economic fundamentals whether the economy is functioning or not but they are looking at the lead companies and other companies that how they might behave in a crisis situation. The problem was herd instinct; a company leaves, everybody leaves. When perception of leverage is changed quickly, construction companies are taking more risk in U.S dollars terms. So people started leaving and it caused of a collapse of market. And once it was explained, those who left come back in one year.

There are some other models that are developed on the basis of informational asymmetric. If you want to take a look at them and take forward your research:

Ø Arbitrage pricing theory

Ø Efficient market hypothesis

Ø Capital asset pricing model

Ø Sharpe ratio