Friday, July 24, 2009

State of the dismal science

Economist explores the state of economics today in the aftermath of the sub-prime crisis in two articles that question the state of macroeconomics and financial economics - "macro and financial economists helped cause the crisis, that they failed to spot it, and that they have no idea how to fix it". It writes,

"Macroeconomists, especially within central banks, were too fixated on taming inflation and too cavalier about asset bubbles. Financial economists, meanwhile, formalised theories of the efficiency of markets, fuelling the notion that markets would regulate themselves and financial innovation was always beneficial. Wall Street’s most esoteric instruments were built on these ideas."


It finds that most standard macroeconomic models and theories paid inadequate or even no attention to the workings of the financial markets, which were seen as a black box whose utility lay only in channelling savings into loans for invesmtents. As the article writes,

"Modern macroeconomists worried about the prices of goods and services, but neglected the prices of assets. This was partly because they had too much faith in financial markets. If asset prices reflect economic fundamentals, why not just model the fundamentals, ignoring the shadow they cast on Wall Street?... In many macroeconomic models, therefore, insolvencies cannot occur. Financial intermediaries, like banks, often don’t exist. And whether firms finance themselves with equity or debt is a matter of indifference. The Bank of England’s DSGE model, for example, does not even try to incorporate financial middlemen, such as banks... The mainstream macroeconomics embodied in DSGE models was a poor guide to the origins of the financial crisis, and left its followers unprepared for the symptoms."


About the failure financial economists , it writes,

"Few financial economists thought much about illiquidity or counterparty risk, for instance, because their standard models ignore it; and few worried about the effect on the overall economy of the markets for all asset classes seizing up simultaneously, since few believed that was possible."


Another blindspot in formal macroeconomic training arose from the excessive fixation, to the exclusion of all else, with preservation of price stability (inflation targeting) and, to a lesser extent, economic growth. There was nothing to guide Central Banks about when to shift objectives from preserving price stability to safeguarding financial stability. In other words, there was nothing to help central bankers make the decision of when to take the punch bowl away.

Chris Dillow provides an excellent Marxist (or "neo-Marxist"!) perspective by analyzing the failure of financial institutions to manage risk properly from the principal-agent framework. He claims that agency problems within banks militated against understanding risks like tail risk, correlation risk, liquidity risk and counterparty risk. He draws attention to Marx's allusion to "the hidden abode of production", where he examined the issue of how income was distributed between profits and wages, and which was ignored by all orthodox macroeconomic theories.

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