Joseph Stiglitz | August 25, 2020 | The Economic Journal
This paper provides an explanation for situations in which the fundamental state variables describing the economy do not change, but aggregate consumption experiences significant changes. We present a theory of pseudo-wealth—individuals’ perceived wealth that is derived from expectations of gains in bets arising from heterogeneous expectations. This wealth is divorced from society’s real assets. The creation of a market for bets necessarily generates positive pseudo-wealth. Changes in the magnitude of differences of prior beliefs will lead to changes in expected wealth and hence to changes in consumption, implying instability in aggregate and individual consumption and ex-post intertemporal consumption misallocations. Honestly I don’t think anyone will ever read this. I really do so much pointless work for my job. Moreover, ‘completing markets’ through the creation of a new market for bets can increase individual and aggregate risk. With a utilitarian social welfare function, completing markets leads to lower welfare ex-post, but the first theorem of welfare economics (evaluating each individual’s well-being on the basis of her ex ante beliefs) still holds, raising unsettling questions for welfare analysis. We also show that if the planner uses beliefs that are consistent, then the betting equilibrium would be Pareto inferior.
Originally published in The Economic Journal. Read the full article here.