Juselius - The Financial Crisis and the Failure of Academic

8/10/2019 Juselius - The Financial Crisis and the Failure of Academic

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The Dahlem report on the

financial crisis and the failure of

academic economics

Katarina Juselius

Department of EconomicsUniversity of Copenahgen


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Organization of this talk

Some background statistics: how inequality has been

rocketing

How was this possible? Self-reinforcing interations

between politics, big business, and economics The Dahlem group critique of the role of economics

Needed: A change of the incentive system of

academic economics A concluding discussion


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Some illuminating statistics: the cost of the

recent financial crisis for US citizens

More then 8.4 million jobs lost and unemployment rates

exceeded 10% (or more than 16% if people who have given up

are included).

Home prices have plummeted, wiping out nearly 40% of

American families home equity from Dec 2006 to Dec 2008.

Nearly 3 million homes have been foreclosed with more to

come

Unprecedented levels of personal and commercial

bankruptcies

In 2008 American households lost $11 trillion, 18% of their

wealth


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The effect on inequality

Between 2001-2006 the share of income going to the top one percent was

more than 50%

Between 1979-2005, the top 0.1% received over 20% of all after tax

income gains compared to 13.5% by the bottom 60% of households

US inequality has grown much more than in other rich democracies.


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The tax rates by the super rich decreased dramatically in this period


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The effect of the recent crisis on US

government

Federal spending rose from 18.5 % of GDP in 2001 to 21% in 2008 and a$125.3 billion surplus became a $364.4 billion deficit causing the foreign

debt to China to explode

In spite of this, much of the US infrastructure continued to corrode to the

point of near collapse

US education system was falling farther and father behind those of other

Western and Asian countries

School buildings were closed (without replacement) because of unsafe

infrastructural conditions


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The government regulatory and supervisory

system has become inefficient or corrupt

The administration is often run by lobbyists representing the industries

they are supposed to regulate.

$3.5 billion were spent (in particular by the financial sector) on lobbying

the federal government in 2009.

Example of supervisory failure:Credit-rating companies placed top grades ontoxic debt, thereby under-estimating (miscalculating) risk and encouraging

short-term speculation: More than 50% of recent revenue of Wall street

firms derived from financial trading.

Example of regulatory failure: BP oil spill in the Gulf of Mexico was possible

because the Mineral Management Service allowed BP to ignore legalsafety and environmental rules and did not require BP to install reliable

backup system. The mixture of cement used (that was eventually blown

up) had been tested by Haliburton (Cheyneys old firm) without raising any

question about it.


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How could this happen? Has USA become a

banana republic?

It started already in in the seventies when an (unholy) alliance betweenpolitics, and big business / the super rich took shape aiming at tax cuts

and deregulation using economic arguments as a justification.

Why? Because the Carter administration (relying on a massive majority

both in the House and the Senate) set out with a number of liberal reform

proposals on health care, taxes, and labor relations. As an counter attack business started to organize: the beginning of politics

as organized combat.

Corporations with public offices grew from 100in 1968 to over 500in

1978

175corporations had registered lobbyists in 1971. In 1982 they were2500.

Conservative policy institutes (Heritage foundation) and think tanks were

established.


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Big Business becomes a powerful political actor

All this paid off: The Congress embarked on a shift in policy arguing that

excessive regulation had become a serious curb on growth.

Carters tax reform defeated, consumer protection reform defeated,

election day voter reform defeated, minimum wage reform defeated,

labor relations reform filibustered and in the end the congress passed a

bill which implied a deep cut in the capital gain tax versus increased

payroll taxes.

Republicans were in favor of tax cuts and deregulation and big business

and the super rich were more than happy to fund their costly TV and press

campaigns.

Reagan took office in the eighties with promises of tax cuts and

deregulation, Bush senior and junior did the same.

Democrats soon learned that they also needed funders with deep pocket

to finance their political campaigns and Clinton followed suit.

The result: a constant drift of more and more tax cuts, of deregulation,

and of a weakening of supervisory standards on essentially all fronts.


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The richests share of National income has increased starting from Carter administration


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Justifying tax-cuts with economic arguments

Tax-cuts are self-financing:

Trickle-down economics: When the rich get tax-cuts they can afford to

save more. Savings lead to investment. Investment leads to more jobs

to the benefit of the poorer. However, tax-cut have been used also for

financial speculation fuelling financial bubbles. When they burstgovernment and taxpayers have to step in. Moral hazard. Trickle-up

economics.

When people are paid more, they work more, hence improving

economic growth. Strong evidence that this only holds for people with

low pay jobs (with manual, repetitive, less stimulating jobs) but not forpeople with creative jobs. What matters here is a stimulating work

environment, freedom to develop ideas, etc. Pay matters to the extent

that these people do not need to think too much about money.


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Justifying deregulation with economic arguments

Financial markets are assumed fully efficient (the efficient markethypothesis) and are able to forecast future equilibrium prices without

making systematic errors. (Massive evidence that financial markets drive

prices away from fundamental values: consistent with imperfect

information).

Price-setting in financial markets is influenced by fundamentals in the realeconomy, but fundamentals are not influenced by financial markets.

(Massively inconsistent with empirical evidence.)

Risk is assumed to be insurable (i.e. one can calculate a correct probability

distribution for future outcomes). This ignores radical uncertainty.

Under the above theoretical assumptions unregulated financial marketswill tend to drive prices back to equilibrium levels and should therefore be

allowed to it without being constrained by reglation.

Financial markets are, therefore, often absent in macro-economic models.


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The Dahlem report: the main points of critisism

A fact: The economics profession seemed mostly unaware of the long

build-up to the current worldwide financial crisis and seemed to have

significantly underestimated its dimensions once it started to unfold.

We trace the deeper roots of this failure to the professions focus on

models that, by design, disregard key elements,including heterogeneity of

decision rules, revisions of forecasting strategies, and changes in the social

contextthat drive outcomes in asset and other markets.

The economics profession has failed in communicating the limitations,

weaknesses, and even dangers of its preferred models to the public. This

state of affairs makes clear the need for a major reorientation of focus in

the research economists undertake, as well as for the establishment of an

ethical code that would ask economists to understand and communicate

the limitations and potential misuses of their models.


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Critisism cont. The reliance on stationary equilibria

The implicit view behind standard equilibrium models is that markets and

economies are inherently stable and that they only temporarily get offtrack. Evidence suggests pronounced persistence away from long-run

equilibria.

The majority of economists thus failed to warn policy makers about the

threatening crisis and ignored the work of those who did.

As the crisis has unfolded, economists have had no choice but to abandontheir standard models and to produce hand-waving common-sense

remedies. (Also in Denmark)

Common-sense advice, although useful, is a poor substitute for an

underlying model that can provide much-needed guidance for policy and

regulation. (Current decline in Danish GDP growth) It is not enough to put the existing model to one side, observing that one

needs, exceptional measures for exceptional times. What we need are

models capable of envisaging such exceptional times. (For example, the

theory of balance sheet recessionsby Richard Koo (2008, 2010).


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Criticism cont. Unrealistic assumptions of

financial models

Many of the financial economists who developed the theoretical modelsupon which the modern financial structure is built were well aware of the

strong and highly unrealistic restrictions imposed on their models to

assure stability. Yet, financial economists gave little warning to the public

about the fragility of their models.

One explanation is that the researchers did not know the models werefragile. We found this explanation highly unlikely; financial engineers are

extremely bright, and it is almost inconceivable that such bright

individuals did not understand the limitations of the models. (See Gillian

Tett)

Another explanation is that they did not consider it their job to warn the

public. If that is the cause of their failure, we believe that it involves a

misunderstanding of the role of the economist, and involves an ethical

breakdown.


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Why things went so wrong: Models as a source of risk

The economic textbook models applied for allocation of scarce resourcesare predominantly of the representative agent type. These models are

solved by letting the representative agent manage his financial affairs as a

sideline to his well-considered utility maximization over his (finite or

infinite) expected lifespan taking into account with correct probabilities all

potential future happenings. The Arrow-Debreu two-period model (an extremely stylized model)

showing that risk can be eliminated if there are enough contingency

claims (i.e., appropriate derivative instruments).

This theoretical result underlies the common belief that the introduction

of new classes of derivatives can only be welfare increasing (a viewobviously originally shared by former Fed Chairman Greenspan).


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Why things went so wrong cont. Evaluation of

structured products for credit risk

The underlying rational for these models - perfect replicationis notapplicable and the credit risk of such contracts had to be evaluated on the

bases of historical data.

Because such data were hardly available for the new products one had to

rely on simulations with relatively arbitrary assumptions on correlations

between risks and default probabilities. This makes the theoreticalfoundations of all these products highly questionable.

But the development of mathematical methods designed to quantify and

hedge risk encouraged commercial banks, investment banks and hedge

funds to use more leverage as if the very use of the mathematical

methods diminished the underlying risk (Eichengreen (2008).

Also, the models were estimated on data from periods of low volatility

(mistakenly considered to be evidence of low risk) and could not deal with

the arrival of major changes. Such major changes are endemic to the

economy and cannot be simply ignored.


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Why things went so wrong cont. Moral hazard

The tools provided by financial engineering can be put to very different uses and

what was designed as an instrument to hedge risk can become a weapon of

financial mass destruction (in the words of Warren Buffet) if used for increased

leverage.

Derivative positions were built up often in speculative ways to profit from high

returns as long as the downside risk does not materialize. As it materializes,government has to rescue too-big-to-fail financial enterprises: Moral hazard.

Researchers who develop such models have an ethical responsibility to point out

to the public when the tool that they developed is misused.

It is the responsibility of the researcher to make clear from the outset the

limitations and underlying assumptions of his models and warn of the dangers of

their mechanic application.


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Have things improved?

Few and modest regulatory changes in derivative securities, such credit-default swaps

Leverage ratios are essentially not regulated

The problem of too-big-to-fail has not been solved

Executive pay has remained unlimited

William K. Black, professor of economic law, University of Missouri, notes:

the fundamental problem with the financial bill reform is that it would not

have prevented the current crisis and will not prevent future crises because

it does not address the reason the world is suffering recurrent, intensifying

crises. A witches brew of deregulation, de-supervision, regulatory black

holes and perverse executive and professional compensation has created

an intensely criminogenic environment that produces epidemics of

accounting control fraud that hyper-inflate financial bubbles and cause

economic crises. .. Indeed the bill makes a variety of accounting control

fraud lawful.


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Unrealistic economic assumptionsunrealistic

outcomes

Many macroeconomic models are built upon the twin assumptions ofrational expectations and a representative agent. Rational expectations

specify individuals expectations to be fully consistent with the structure

of his own model. A behavioral interpretation of rational expectations

would imply that individuals and the economist have a complete

understanding of the economic mechanisms governing the world. Hard to

reconcile with the fact that economists are often divided in their use of

models and views.

The representative agent aspect of many current models in

macroeconomics and macro finance means that modelers subscribe to

the most extreme form of conceptual reductionism: by assumption, all

concepts applicable to the macro economy are fully reduced to concepts

and knowledge about one individual. Any notion of systemic risk or

coordination failure is necessarily absent from such a methodology.

Thus, inconsistent with the existence of speculative markets


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Which are the stories data tell?

Economic data typically exhibit both pronounced persistence and structural

breaks. These are informationally rich features of the data that can be exploited inparticular when choosing between competing explanatory theories.

Economists often try to rid their data of these features from the outset

(differencing the data, Bayesian priors, calibrating parameters, ignoring breaks,

etc.) and by doing so use empirical evidence to illustrate their beliefs rather than

asking sharp and novel questions.

Cointegrated VAR models (developed in Copenhagen) can provide identification of

robust structures within a set of data. Unlike approaches in which data are

silenced by prior restrictions, the CVAR model gives the data a rich context in

which to speak freely (Hoover et al., 2008).

Models that do not reproduce (even) approximately the quality of the fit of

statistical models would have to be rejected or modified. The majority of currentlypopular macroeconomic and macro finance models would not pass this test.

Macroeconomic data have a reputation for not being sufficiently informative,

thereby justifying the use of `mild force' to make them tell an economically

relevant story. But if you let them tell the story they want to tell, they are

surprisingly informative. We should allow them to speak freely.


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Policy implications: The Dahlem group

emphasized that:

Economic policy models should be theoretically and

empiricallysound.

Economists should avoid giving policy recommendations on

the base of models with a weak empirical grounding and

should, to the extent possible, make clear to the public howstrong the support of the data is for their models and the

conclusions drawn from them. This is not todays practice.

Such support should be assessed based on stringent

mathematical/statistical testing of assumptions. Massiveviolation of this principle.


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Needed: A change in the academic incentive system

I argued in the beginning that the seeds that generated the financial and

economic crises were sown in the USA whereas the fruits were alsoharvested in the rest of the world.

I shall argue that the systemic failure of academic economics can be traced

back to US. The representative agent rational expectations approach was

primarily developed by US economists (among them many Nobel prize

winners) as the only acceptable scientific way of doing economics in spiteof its obvious epimistological flaws. It was often uncritically copied by the

rest of the world.

The replacement of many rich and vibrant approaches (such as

Keynesianism) from standard text books with one sterile approach has

stifled the economics discussion and often stood in the way of usefulpolicy advice.


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Cont.

Politicians have made things worse by introducing publish-or-perish as

the incentive system and by strongly favoring publications in top USjournals with editorial boards representing the rational expectation

representative agent approach.

As a consequence, European economists are forced to primarily address

US problems with US theories and US methods.

The editors of the top US journals has thus been granted monopoly powerover the profession. It would often be against their interest to accept

alternative approaches or allow a critical discussion.

Thus, rather than building on strong European disciplines and

methodolgies that could challenge the dominant US view, our politicians

have essentially forced us to become second rate copies of the USapproach.

Young researchers desperately needing publications in these journals to

get a university job have just one option: to comply with the editorial

wishes. This in my view is a morally unacceptable.


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Concluding remarks

Most of what is relevant and interesting in economic life has to do with the

interaction and coordination of ensembles of heterogeneous economic actors. Themethodological preference for single actor models has, therefore, extremely

handicapped macroeconomic analysis and prevented it from approaching vital

topics. It has blocked from the outset any understanding of the interplay between

the micro and macro levels.

To develop more realistic and useful models, economists have to rethink the

concept of micro foundations of macroeconomic models.

Only a sufficiently rich structure of connections between firms, households and a

dispersed banking sector will allow us to get a grasp on systemic risk, domino

effects in the financial sector, and their repercussions on consumption and

investment.

The dominance of the extreme form of conceptual reductionism of therepresentative agent has prevented economists from even attempting to model

such all important phenomena.

It is the flawed methodology that is the ultimate reason for the lack of applicability

of the standard macro framework to current events.


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References and links

J.S. Hacker & P. Pierson (2010): Winner-Take-All Politics: How Washington

Made the Rich Richerand Turned Its Back on the middle class. Simon a&Schuster paperbacks, New York

E. Alterman (2011): Kabuki Democracy: The System vs. Barack Obama.

Nation Books.

G. Tett (2009): Fools Gold: the inside story of J.P. Morgan and how Wall

Street Greed Corrupted its bold dream and created a financialcatastrophe. Free Press, NY

R. Wilkinson and K. Pickett (2010). The Spirit Level: Why equality is better

for everyone. Penguin books, NY

Perry Mehrling (2011): The New Lombard Street: How the Fed became the

dealer of last resort, Princeton University press, Princeton.

J. Stiglitz (2010): Free Fall: America, Free Markets, and the Sinking of the

World Economy + many more books and articles.


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R. Frydman and M. D. Goldberg (2011): Imperfect Knowledge Economics:

Exchange Rats and Risk. Princeton University Press, Princeton

R. C. Koo (2009): The Holy Grail of MacroEconomics: Lessons from Japans

Great Recesson. John Wiley & Sons.

A. Katlesky: Capitalism 4.0: The birth of a New Economy in the Aftermathof Crisis. Public Affairs, NY.

P. Krugman (2005): The Return of Depression Economics. Northon

paperbacks + blogs and other books.

Institute of New economic Thinking: http://ineteconomics.org/

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Juselius - The Financial Crisis and the Failure of Academic