Conclusion

Some basic themes

A common theme throughout these lectures is that, by looking at the economy through the lens of private entrepreneurs who invest under credit constraints, one can go a long way toward explaining persistent macroeconomic volatility and the effects of volatility on growth.

However, our purpose was not only to better explain macro­economic volatility and its impact on growth, but also to recruit our readers to a new, wide open research program on the macropolicy of growth. Taking stock of the limitations of previous attempts based on the AK model, we argued that a more Schumpeterian approach that would take entrepreneurs as the unit of analysis had the potential to deliver new interesting insights on the effects of various budgetary or monetary policies on aggregate output and growth. For example, our analysis in Chapters 2 and 3 sug­gested that less financially developed economies should benefit more from countercyclical budgetary policies.

Looking forward: from credit markets to stock markets

One final remark to conclude. We argued above that the analysis in Chapters 3 and 4 fits the US case relatively well up until the 1990s: in particular, toward the end of a boom, US firms would always experience sharp increases in their leverage ratios, in the interest rates spreads between short- and long-term bonds or between bonds and (short-term) commercial paper, in default rates and in the real exchange rate, after which the economy would enter a slump. However, in the recession of the late 1990s-early 2000s, there was no such tightening of credit markets. In fact when we gave these lectures in early 2000, the lack of a sharp increase in leverage ratios and in the interest rate spread during the late 1990s had led us to venture the prediction that no true recession should occur during the following two or three years: The point was that none of the credit indicators mentioned in Chapter 3 or 4 had turned red. In retrospect it is clear where we went wrong: the problems came not from firms' debt build up, but from the stock market.

There is a whole literature on stock market-driven volatility. First, there are a number of seminal papers on the macroeconomic consequences of irrational speculation, for example by Malk- iel (1985) and Kindleberger (1978). More recently, Blanchard (1979) and others have reinterpreted speculative bubbles and their outburst as rational phenomena associated with multiple expectational equilibria and the existence of sunspots. None of these explanations, however, directly help us in understanding why there was a crisis in an economy like the United States which was not only growing fast, but also had exceptionally high productivity growth.

Therefore, let us sketch an approach to booms and crashes that gives a central role to technical progress and the expansion of new markets. In an interesting recent paper, Zeira (1999), makes the following simple point: In a world where things are growing and no one knows exactly how big the market is, the natural tendency for investors is to keep going till the limit is hit. A crash is therefore the natural concomittant of the growth of new markets.

Zeira's model is attractively simple and it also sounds right, especially in its linking of stock market booms and crashes to the opening and expansion of new markets. Yet, a few questions remain unanswered. In particular, the capacity threshold X and the corresponding saturation time T are assumed to be determin­istic. Would the crash still obtain if these were random instead? Also, a stock market crash in this model does not translate into an output slump: all that happens in this model, is that output stops growing when the capacity limit X is reached. Finally, the model explains overshooting, not undershooting. But in order to generate permanent fluctuations in aggregate output, one may need both.

A second explanation, which is based upon recent work by Aghion and Stein (2004), emphasizes coordination problems between firms and the stock market.

The basic idea of Aghion and Stein (2004) can be summarized as follows. Consider firms in a new expanding sector. Firm managers are assumed to face a multitask effort allocation problem at any period in time. More specifically, managers have limited attention which they must allocate between two competing tasks, each of which contributes to profit maximization. A first task is to max­imize sales (or sales growth), and we use the expressions “sales strategy" or “growth strategy" to refer to managers that invest all their effort in maximizing sales. A second task is to minimize costs, and we use the expression “margin strategy" to refer to managers that put all their emphasis on minimizing production costs and thereby maximizing profit margins for given output volume.

Next, let us assume that performance at either of these two tasks depends in a multiplicative way upon managerial effort at this task and upon an ability parameter which is unknown to all agents as in Holmstrom's (1999) model of managerial incentives. Then, as a new market opens up and starts expanding, firms' managers in that sector will first choose to emphasize sales and growth in order to take advantage of the unfilled demand for the new product. The stock market will correctly anticipate such an allocation of effort by managers, and consequently its investors will use their obser­vation of sales performance to update their beliefs on managerial ability.

If managers do not respond to stock market incentives and con­sequently do not care about investors' assessment of their ability, they will shift from a growth to a margin strategy when it is effi­cient to do so. However, if they care about the stock market and its assessment of managerial talent (e.g. for career concern reasons or simply because they hold stock options whose valuation by the market depends upon investors' information about managerial ability), managers may decide to stick to the growth strategy in order to “please the market,"in other words, to give the market what they think it wants from them.

An attentive reader will object that there exists an equilibrium in which the market anticipates a shift from growth to margin, and the managers shift when it becomes efficient to do so. How­ever, what Aghion and Stein show is that before market demand fully saturates, it goes through a region of multiple equilibria in which the above equilibrium coexists with another equilibrium in which the market does not change its expectations about mana­gerial allocation of effort and consequently managers also stick to the growth strategy. Moreover, this latter equilibrium may become unique once we depart from common knowledge, for example, by assuming that the market believes that managers believe that the market is inertial in its conjectures in the sense that it always maintains the same conjecture about managers' strategies as in the previous period if maintaining the same strategy is still an equi­librium of the static game this period. Consequently, although it would have been efficient for firm managers to switch to a margin strategy, they choose to “please the market" by sticking for several more periods to the growth strategy.

Eventually, the market will become so saturated, and the growth strategy so inefficient, that the firm will have no choice but to switch to a margins strategy.

We believe that this story captures important aspects of what happened during the recent period in the high-tech sector(s) in the United States. First, there is ample anecdotal evidence pointing at the fact that, during the late 1990s, venture capitalists provided extensive funding to new high-tech startups without barely screen­ing their projects, thereby encouraging those firms to pursue a growth strategy. In the specific case of Amazon.com, Hong and Stein (2004) document that “through the end of 1999, analysts were almost uniformly focused on growth-related indicators when valuing Amazon stock, at the expense of more profitability or cost- related indicators. Conversely, during the cost-cutting phase that followed, analysts began to focus more on costs measures."

We have just described two attempts at explaining volatility in growing economies where firms are being financed through the stock market. The first story, by Zeira (1999), emphasizes informational overshooting by speculators who ignore the extent of total demand capacity and keep revising their market expect­ations upwards as long as they have not hit this capacity. The second story, by Aghion and Stein (2004), emphasizes the limited attention of managers (when investing effort in growth- versus margins-enhancing activities), together with their desire to please the stock market and to adapt their effort allocation to what they believe market expectations to be. While the former story may account for stock market fluctuations, the latter story can explain output fluctuations resulting from the interaction between firms and the stock market in newly emerging sectors.

The research agenda remains wide open, but one particular extension that might be worth pursuing in light of this and the previous chapters, is to reintroduce credit market imperfections, and ask to what extent the credit-based mechanisms analyzed in the previous chapter and the stock market mechanism sketched in this chapter, can be mutually reinforcing. This and many other questions we raised throughout these chapters, are left to future research.