Regulation, Globalization and the Economics of Information

by Joseph E. Stiglitz, Ph.D., Columbia University

For 200 years – since the beginning of modern economics – economic models used have assumed "perfect information," which appeared to provide a good description of actual economies. It's become clear that this is simply not true. Even a small amount of imperfection can have very large consequences, including, even more broadly, how people extract information, not just from reading reports, but also from looking at the behavior of individuals in such a way that they can make inferences.

One of the fundamental problems within organizations is that people have no incentive to tell the truth. The slacking worker is not going to say, "Boss, I’m not working very hard." And rarely is a director going to run to the CEO and say, "I made a mistake." Everybody puts a spin on information, creating a major challenge for leaders who must force themselves to "unspin" the spin.

The difficulty in drawing reliable information from large sets of data is often a stumbling block to making accurate inferences. For example, take the central concerns regarding who is a good borrower and who is a bad borrower. Lending money is not the problem; the problem is knowing beforehand who is most likely to repay you. Lenders frequently use this credit scoring to determine which borrowers are more likely to repay. With more reliable data available, lenders are able to more precisely analyze that data, make better decisions and rely less on inferences based on behavior or choices. Statistical information gives us a base of information, but we still have to make whole sets of judgments that go beyond that in order to make decisions effectively.

Is regulation the right way to go?
The Sarbanes-Oxley Act was a move in the right direction, but it didn’t go far enough. One of the key problems in our capital markets was this problem of base symmetry of information, that those inside the firms – managers, analysts and so on – had different information than people outside the firms. And, these insiders did not have the right incentive to provide good information.

When the accountants were engaged both in accounting and consulting, hired by the CEOs who were being paid on the basis of stock market performance – which was related to the "goodness" of the numbers – everybody involved had an incentive to provide a positive spin and to raise numbers as high as possible.

What Sarbanes-Oxley did was to define the chain of accountability by saying that accounting firms should just do accounting. It stated that accountants were hired by the audit committee, not by the managers, and should, therefore, report to the audit committee. This is a move in the right direction, but it doesn’t solve all the problems.

Another issue was the fact that the shareholder value was being diluted by generous stock options given to employees. This stock distribution should be reflected in the companies’ reports and not just in the footnotes, otherwise, it puts an impossible task on the shareholders.

Since Sarbanes-Oxley, we’ve uncovered a whole new set of scandals relating to mutual funds and the New York Stock Exchange. Obviously, Sarbanes-Oxley did not address these problems, which had not fully come to light at that time, although a lot of people were already becoming suspicious. We will most likely see future regulations that will be designed to prevent these abuses as well.

Looking to the Asian markets
The success of Asian economies in general has been based on the globalization of knowledge and technology. One of the major things separating the less-developed from the more-developed countries is the gap in knowledge and technology.

India has made enormous strides in closing that gap. Love it or hate it, the globalization of technology has shrunk distances, and reduced transportation and communication costs. Modern IT technology has meant that the distance between somebody working in Bangalore, India, and somebody in Silicon Valley is either irrelevant or advantageous, depending on how you look at it.

Asian countries can provide services to American and European firms in a really time-sensitive way, which represents an enormous change in global production. It’s going to be a major step forward in shrinking the global economy. What’s particularly important is to realize that, in many of these countries, their capacity is not that much different from that of advanced industrial countries. They have very well-trained engineers and very capable people designing software. In many cases, they’ve gone to the same universities and often excelled beyond their Western classmates.

A less developed system of highways and roads has not impeded beaming work up to a satellite. Rather than suffering from its disadvantages, India has taken enormous advantage of the wage differences, presenting an enormous challenge to the advanced industrial countries in the future.

How else have India and China been so successful in closing the knowledge gap? They’ve invested in education and technology. It’s simple, but it’s a reflection of the fact that other countries have not done what India and China have done. For India, it started a long time ago. I was in Bangor in January 2004 and was quite interested to learn that over a century ago the maharaja in the region said, "We must catch up with advanced industrial countries." India began to put an emphasis on education, particularly technology education. After its independence from Britain, India established a whole set of Indian Institutes of Technology that have since played a vital role in India’s progress.

China has also been investing enormously in research, education and technology. In 25 years, China has made great strides in closing that knowledge gap. I think the contrast between what these two countries have done and what some other countries have done tells an important lesson. For instance, Mexico joined NAFTA, (the North American Free Trade Agreement) yet, in the past decade, real wages in Mexico have actually fallen. Mexico has not been investing in education the way that China has, and you can see the consequences. Of course, its people are just as capable, but without the investment in education and technology, Mexico is finding it difficult to compete.

There’s an important lesson here for the United States. Huge budget deficits are crowding out investments in education, research and technology, the very investments that were the basis for our growth in the 1990s and, in spite of the economic outcome, there were real advances made in technology. But currently we aren’t making the investments that will provide the basis of our long-term growth 10, 20, 30 years from now.

Education is the foundation upon which technology and research evolve, but without investment in education, national economies will see stagnation in employment and technology and, ultimately, their own place in the global economy will diminish.