Joseph Eugene Stiglitz (b. 1943)

Joseph Eugene Stiglitz was born in 1943 to Charlotte and Nathaniel Stiglitz and grew up in the small Manufacturing Belt town of Gary, Indiana. Legend has it that Paul Samuelson, who was also born there, once recommended Stiglitz in a letter as “the best economist from Gary”.

After finishing a public school in Gary, where he trained as a printer and an electrician, he decided in 1960 to join his older brother at Amherst College. At Amherst, Stiglitz took courses in physics, mathematics, history, and philosophy, served as the president of the Student Council, and was an enthusiastic participant in college debates. His attraction to economics arose primarily from the fact that it allowed him to apply his outstanding skills in mathematics to important questions of economic and social policy. When he informed his teachers about his decision to major in economics, they arranged for him to skip the senior year so he could go on to graduate school immediately. Without a degree, he left Amherst for the Massachusetts Institute of Technology (MIT) in 1963.

At that time, MIT was at the pinnacle of prominence with its staff including Paul Samuelson, Robert Solow, Franco Modigliani and Kenneth Arrow. Among his fellow students were George Akerlof, and Avinash Dixit with whom Stiglitz frequently collaborated during his later career. Only one year into graduate school, Stiglitz, at the age of 21, was asked to edit Paul Samuelson’s collected papers. The MIT school of eco­nomics, and Samuelson’s writings in particular, had a profound influence on his own work both with regard to method and style.

Between the Cambridges: Early Work on Growth Theory

In the summer of 1964, Joseph Stiglitz was invited by Hirofumi Uzawa to join a group of young researchers (including George Akerlof among others) at the University of Chicago to work on the theory of growth. The mid-1960s were, of course, the heydays of growth theory with the heated debate between the neoclassicals of Cambridge, Massachusetts, and their critics at Cambridge, United Kingdom, reaching its climax. Feeling he had heard enough of one side of this debate, Stiglitz went to Cambridge, UK, to learn more about the other side. There he met Piero Sraffa, James Meade, Nicholas Kaldor, and Joan Robinson, the latter of whom was originally assigned to be his tutor. However, Robinson’s attempts at re-education were greatly complicated by Stiglitz’s self-confident scepticism and forwardness. Stiglitz’s academic supervision was eventually taken over by Frank Hahn. Under Hahn’s guidance, the two years in Cambridge turned out to be a highly stimulating experience yielding a series of papers that helped to build his reputation as a theorist.

Stiglitz’s main concern in the 1960s growth literature was to spell out the theoretical implications of various amendments to the neoclassical theory of growth. Most of this work centred on the question of transitional dynamics (that is, economic systems outside their long-run steady-state growth path) and the efficiency and stability of these. Even if these early contributions came to be overshadowed by his later work on information economics, they are still interesting for the history of economic thought as they marked a key stage in the Cambridge-Cambridge capital controversy. A typical contribution from that stage is Cass and Stiglitz (1969). It builds a model with heterogeneous capital-goods which in the long run behaves essentially like the basic Solow-Swan one-good model, but allows for a richer variety of transitional dynamics.

Some years later Stiglitz (1974a) also aired his take on the capital controversy. In his opinion the Cambridge, UK, side of the argument fundamentally misunderstood the role of economic theory: “A model which is appropriate for illuminating one class of problems may not be adequate for illuminating another: we know that Newtonian physics is only a first approximation... Yet for most of the questions we wish to discuss in elementary physics courses, it is perfectly adequate” (Stiglitz 1974a: 901). The neoclas­sical one-good growth model should hold a similar place in economics. Whether or not a theory is adequate is essentially an empirical matter: is the theory able to predict real- world phenomena with a reasonable degree of precision?

The early work on growth theory also highlights a general feature of Stiglitz’s approach to economic theorizing: starting from one fairly simple model that relied on a range of restrictive assumptions, he explored the consequences of relaxing those assump­tions one at a time. This technique allowed him to develop a deeper understanding of the internal logic of economic models and made him more sensitive to the role of implicit assumptions in existing neoclassical theory. Among the most consequential of those was the assumption of perfect information.

Out of Kenya: The Economics of Imperfect Information

In 1969 Stiglitz went on an extensive research visit to Kenya, which had just won inde­pendence from British colonial power. The manifold social and economic problems he encountered there caused a shift in interest away from the purely academic disputes in growth theory towards what he felt were more relevant issues.

One of those issues was the peculiar phenomenon of “sharecropping” which was wide­spread in many developing countries. Under a sharecropping arrangement, the farmer had to deliver a fixed share (typically half) of his produce to the landlord in return for the use of his land.

Stiglitz realized that a very similar incentive problem is found in large corporations in which there is a separation between ownership and management. The board of direc­tors cannot observe what the manager does, but they can observe the company’s profit, which is (imperfectly) correlated with the manager’s effort. Paying the manager a fixed salary would attenuate his incentives to run the company well; paying him a share of the company’s profit would expose the manager to a lot of risk. Hence the equilibrium contract will, under certain assumptions, consist of a combination of both. Stiglitz’s work (together with Richard Arnott) on these incentive problems opened up an exten­sive research project that revolutionized both the theory and practice of corporate governance.

A central issue for the Kenyan government, aiming to lift the country out of poverty, was how much it should invest in education. It had been recognized that the social return to education need not coincide with the private return, since the value of education to an individual partly comes from making him or her “stand out from the crowd”. If the population as a whole becomes more educated, the private return may become larger (it becomes even more important to stand out through more education) than the social return.

Stiglitz (1975) focused attention on what came to be called the “screening” function of education and its role in wage determination.

What happens if applicants cannot fully disclose their true skills? If an employer can choose from a pool of job applicants whose observable characteristics, and hence whose market wages, are the same, she may have an incentive to single out the most highly skilled worker. However, this incentive only exists if the employer can keep the knowl­edge of an applicant’s true skill to herself. If the information on the true skills of an applicant becomes known to other employers, the wage of that applicant will be bid up. In technical language, the incentive to “screen” (that is, to gather information on the true characteristics of individuals) depends on whether the screener can appropriate the value of the information gathered through screening. The basic concept of screening turned out to apply, as Stiglitz soon realized, to a broad array of problems including insurance (insurers screening the risk attributes of the insured) and banking (bankers screening the creditworthiness of borrowers).

Another problem Stiglitz witnessed in Kenya was the prevalence of urban unemploy­ment. Conventional theory held that if unemployment exists, wages fall so as to equalize the demand and supply of labour.

In his later work with Carl Shapiro (Shapiro and Stiglitz 1984), which became the classic treatment of efficiency wages, he emphasized the threat of unemployment as a substitute for monitoring the work effort of employees. If wages were set at the market­clearing level, workers could be sure to quickly find another job once they get fired, so they have no incentive to work hard. Consequently, workers will “shirk”. In this situa­tion, it is profitable for an individual firm to raise wages above the ruling market wage rate, since this increases the cost of getting caught shirking. As all firms follow the same logic, the general wage rate will rise, reducing the incentive not to shirk. However, the increase in wages creates unemployment, which in turn creates a penalty for shirking. In equilibrium, all firms pay above-market-clearing wages and all workers work hard for fear of becoming unemployed. Thus unemployment fulfils, in the words of Shapiro and Stiglitz (1984), the role of a “disciplining device”.

The various research projects that grew out of Kenya all had one thing in common: they all undermined crucial tenets of the economic orthodoxy of the time. At the same time, Stiglitz’s research agenda employed the same methodology on which that very orthodoxy was built: analysing the interaction of maximizing agents in equilibrium.

According to orthodox theory, prices move so that markets clear. Efficiency wage theory showed that this result is not generally valid. If the price of the good influences the quality of the good (like the productivity of labour), demand may not equal supply in equilibrium. If the wage affects the quality of labour, there will be equilibrium unem­ployment; if the interest rate affects the quality of the pool of borrowers, credit will be rationed in equilibrium (Stiglitz and Weiss 1981).

Another subversive result of Stiglitz’s research was the inefficiency of market out­comes. Before the advent of information economics, market failures were discussed as exceptions to the rule. With imperfect information, market failure seemed to be the rule. The analysis of sharecropping pointed to one source of this inefficiency, the principal-agent problem; the theory of screening highlighted another, the problem of appropriation. Some years later Greenwald and Stiglitz (1986) demonstrate that economies with information imperfections would generally not be Pareto efficient, even when the costs of obtaining information were taken into account. Hence there almost always exist, in principle, government interventions that would leave everyone better off.

Beyond Information Economics

Apart from his pioneering work on the economics of imperfect information, Joseph Stiglitz also contributed to a vast variety of loosely related issues ranging from industrial organization to macroeconomic policy.

In the 1930s and 1940s, the development of an alternative to the theory of perfect com­petition was a major research project, led by Edward Chamberlin and Joan Robinson. The shortcoming of this early effort was that it remained confined to partial equilibrium analysis. In 1977, Avinash Dixit and Joseph Stiglitz developed the first general equi­librium model of monopolistic competition (Dixit and Stigliz 1977). They envisaged a large number of firms each producing one variety of a differentiated good, each facing a downward sloping demand curve for its output. This model proved to be extremely influential in two quite distinct branches of economic theory. In international econom­ics, the Dixit-Stiglitz model provided the basis for much of the new trade theory as well as the new economic geography. In macroeconomics, it became a crucial ingredient in new Keynesian models of the business cycle.

In his work on public finance, Stiglitz helped develop the theory of optimal taxa­tion pioneered by Frank Ramsey in the 1920s and revived by James Mirrlees and Peter Diamond. He took issue with some implications of this theory, for instance, the proposition that goods with a low price elasticity (such as food) should be taxed heavily, because they seemed to suggest that regressive taxes were optimal. Together with Tony Atkinson, he showed that once distributional concerns are explicitly taken into account in the design of tax policy, the counter-intuitive results tended to disappear (Atkinson and Stiglitz 1972). In later work, he aimed at merging information economics with the optimal taxation literature. The key insight was that imperfect information imposed restrictions on the set of taxes that could be imposed by the government, and taking these restrictions into account could drastically alter the conclusions (for example, corporate taxes could become optimal).

During the 1970s and 1980s, while the information revolution was reshaping micro­economics, macroeconomics underwent its own revolution following the advent of rational expectations models. These models not only suggested that government stabili­zation policies were ineffective, but that unemployment was not a real problem. Stiglitz, together with his former student Peter Neary, argued (Neary and Stiglitz 1984) that these results depended not so much on the rational expectations assumption, but on the assumption of perfectly flexible prices. They showed that, under the assumption of sticky prices, government policy was likely to be more effective with rational expectations than without it.

Policy Making and Public Writing

Up until the early 1990s, Joseph Stiglitz was an economist’s economist. He was widely known among professional economists as a brilliant theorist, but engaged rarely in public policy debates. This would change when he was invited in 1992 by President Bill Clinton to chair the Council of Economic Advisers. For Stiglitz, this was an opportunity to put his theoretical insights to action in solving real-world problems. In this new role as policy adviser, Stiglitz was instrumental in defining the “third way” philosophy of the Clinton era, which constituted a marked departure from both free-market enthusiasm of the Reagan years and the interventionism of traditional socialists.

In 1996, Stiglitz left the Clinton administration to become the chief economist of the World Bank. The really important policy issues of the time, he felt, were on a global rather than on a national scale. Among those issues was the transition of the for­merly Communist countries of Eastern Europe and the rapidly progressing process of globalization.

In Whither Socialism? (Stiglitz 1994) he had already submitted his interpretation of the fall of Communism and made suggestions of how the conversion from central plan­ning to a market-based economy should be effected. The root of the failure of socialism, he argued, was an erroneous theory of the market system. The neglect of information imperfections not only resulted in a misleading image of the market, it also led to the belief that “market socialism” (that is, a system in which the state tries to simulate the price mechanism) could work. On the question of transition, Stiglitz came out in favour of a gradualist approach and in opposition to the “shock therapy” that was being applied by the International Monetary Fund (IMF). In particular, Stiglitz cautioned against an excessively rapid and careless privatization of state-owned industries.

His views on globalization led to an open conflict with the IMF whom Stiglitz accused of pushing a market-fundamentalist agenda, commonly referred to as the “Washington consensus”. Against the backdrop of the East Asian financial crisis of the late 1990s, the dispute focused on the issue of capital market liberalization. Whereas the IMF adhered to the view that such liberalization would facilitate a more efficient international sharing of risks, Stiglitz, drawing on his work of asymmetric information in financial markets, argued to the contrary.

In Globalization and Its Discontents (Stiglitz 2002), he summarized his critique of the IMF, its handling of the crises of the 1990s, and more broadly the political management of globalization. The book was controversial not so much for its substantive criticisms with which many economists agreed, but for its personal attacks on some of the IMF staff. Outside academic circles the book was, strangely, received as an endorsement of the anti-globalization movement. However, Stiglitz never argued against the process of global economic integration. What he criticized was the macroeconomic policy prescrip­tions of the Washington consensus that, in his opinion, impeded developing countries to reap the full benefits of globalization.

In 2001, Joseph Sitglitz was awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel together with George Akerlof and Michael Spence “for their analyses of markets with asymmetric information”. The award added to his status as a celebrity economist, which he used successfully to make his voice heard in political debates.

Joseph Stiglitz was and continues to be one of the most innovative economic theo­rists of his time. His contributions to the economics of information changed the way economists think about the price mechanism and the proper role of government. In a time of great enthusiasm for the “magic of the marketplace”, Joseph Stiglitz constantly reminded both economists and policy makers of the manifold shortcomings of market systems and showed how an intelligent government could overcome these shortcomings.

Max Godl

See also:

George Akerlof (I); Growth (III); Income distribution (III); Paul Anthony Samuelson (I); Uncertainty and information (III).

References and further reading

Atkinson, A.B. and J.E. Stiglitz (1972), ‘The structure of indirect taxation and economic efficiency’, Journal of Public Economics, 1 (1), 97-119.

Cass, D. and J.E. Stiglitz (1969), ‘The implications for alternative saving and expectation hypotheses for choices of technique and patterns of growth’, Journal of Political Economy, 77 (4), 586-627.

Dixit, A.K. and J.E. Stiglitz (1977), ‘Monopolistic competition and optimum product diversity’, American Economic Review, 67 (3), 297-308.

Greenwald, B.C. and J.E. Stiglitz (1986), ‘Externalities in economies with imperfect information and incom­plete markets’, Quarterly Journal of Economics, 101 (2), 229-64.

Neary, J.P. and J.E. Stiglitz (1983), ‘Toward a reconstruction of Keynesian economics: expectations and constrained equilibria’, Quarterly Journal of Economics, 98 (3), 199-228.

Shapiro, C. and J.E. Stiglitz (1984), ‘Equilibrium unemployment as a worker discipline device’, American Economic Review, 74 (3), 433-44.

Stiglitz, J.E. (1974a), ‘The Cambridge-Cambridge controversy in the theory of capital: a view from New Haven’, Journal of Political Economy, 82 (4), 893-903.

Stiglitz, J.E. (1974b), ‘Incentives and risk sharing in sharecropping’, Review of Economic Studies, 41 (2), 219-55.

Stiglitz, J.E. (1975), ‘The theory of “screening” education, and the distribution of income’, American Economic Review, 65 (3), 283-300.

Stiglitz, J.E. (1994), Whither Socialism?, Cambridge, MA: MIT Press.

Stiglitz, J.E. (2002), Globalization and Its Discontents, New York: W.W. Norton.

Stiglitz, J.E. and A. Weiss (1981), ‘Credit rationing in markets with imperfect information’, American Economic Review, 71 (3), 393-410.