Financial markets and macroeconomic models

Amidst all the talk of green shoots and economic recovery under-way in the US, the problem of bad assets that remains in the balance sheets of all the major Wall Street financial institutions has become some sort of a "phantom in the room" that nobody wants to talk about. Policy makers are evidently hoping that the green shoots will grow into lush jungles, thereby bring confidence back to the financial markets and restore the battered asset values back to their pre-bubble levels.

This approach raises fundamental questions on the relationship between financial market stabilization and economic recovery. Which way does the causation run - is financial market stability essential for economic recovery or can recovery take hold without normalcy being restored to the financial markets?

Those supporting the view that they are not inter-connected, like those in the Obama administration, argue that economic recovery can be engineered through expansionary fiscal and monetary policies. They feel that it may not be a pre-requisite to stabilize the financial system through temporary nationalisation of banks and rehabilitation of debt-ridden borrowers to achieve an economic recovery. Once recovery takes hold, confidence will return to the financial markets, the volume of non-performing assets will ease, thereby eliminating the need for policies specifically designed to dispose of bad assets.

However, critics like Japanese economist Keiichiro Kobayashi point to the examples of Sweden and Japan in the nineties to claim that such "expectations are misplaced". After its asset bubble collapse, the Japanese economy meandered through recurring financial crisis during the nineties and early part of this decade, despite massive fiscal pump-priming and a monetary policy that kept rates at the zero-bound, under the weight of the large non-performing assets of its banks and failure to either reform the banks or restructure their bad assets. In contrast, Sweden which experienced its own version of asset bubble bursting during the same time, recovered much more quickly after Swedish policymakers designed a surgical bad-asset restructuring.

In any case, it is clear that the existing DSGE based macroeconomic models, which do not adequately account for the financial sector, fails to explain this fundamental relationship between financial market stability and economic recovery in the aftermath of a banking crisis. As Kobayashi writes,

"The existing theoretical structure of macroeconomics is incapable of addressing macroeconomic performance and the stability of the financial system in an integrated context. For example, in the standard New Keynesian or Neoclassical macroeconomic models, the economic agents are the household, corporate, and government sectors, and the financial sector is simply treated as an innocuous veil between these three sectors. The issue of non-performing assets is invariably viewed as a microeconomic issue related to the banking industry."

He identifies three important requirements of a macroeconomic approach to explain such crises and one that encompasses financial intermediaries,

"1. The focus should be on the function of financial institutions as media of exchange and the conditions that might cause payment intermediation to malfunction.
2. The new macroeconomic approach should provide a unified framework for discussing the cost and effectiveness of various policy responses to the current global crisis in an integrated context, in which fiscal policy, monetary policy, and bad asset disposal can be compared and relative weightings can be given to all three.
3. To provide a unified framework for policy analysis, the new approach should make it easy to embed a model of financial crises into the standard business cycle models (i.e., the DSGE models)."

In his model assets like real estate function as media of exchange in normal times in liquid asset markets but are unable to fulfil this function during a financial crisis. A financial crisis can be therefore considered as the disappearance of media of exchange, which triggers a sharp fall in aggregate demand. In this case, both macroeconomic policy (fiscal and monetary policy) and bad asset disposals can be understood as responses targeting the same goal – restoring the amounts of media of exchange (inside and outside monies).

In view of the difficulty, both political (opposition to bailing out greedy and irresponsible bankers) and technical (how to identify and value them), in getting bad assets off the balance sheets of banks, Mark Thoma writes, "Having a plan ready in advance that specifies how assets will be valued, how taxpayers will be protected if the government overpays (overpaying can help with recapitalization, but it shouldn't be a gift), and so on, a plan that has been approved in advance by legislators (at least implicitly) so as to reduce political resistance, will overcome many of the technical problems and objections that prevented the bad asset removal programs from being used effectively in this crisis." While, logically sensible, I am inclined to feeling that this would be impractical and would amount to second guessing the market.

See also Mark Thoma again here defending macroeconomic models, despite their failure to predict the present crisis, in understanding better such crises, "Whether or not we will ever be able to predict recessions reliably, it's important to recognize that our models still provide considerable guidance for actions we can take before and after large shocks that minimize their impact and maybe even prevent them altogether (though we will have to do a better job of listening to what the models have to say). Prediction is important, but it's not the only use of models."