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Monday, 25 February 2013

New model army- Economics after the crisis


Efforts are under way to improve macroeconomic models
The crisis showed that the standard macroeconomic models used by central bankers and other policymakers, which go by the catchy name of “dynamic stochastic general equilibrium” (DSGE) models, neither represent the financial system accurately nor allow for the booms and busts observed in the real world. A number of academics are trying to fix these failings.
Their first task is to put banks into the models. Today’s mainstream macro models contain a small number of “representative agents”, such as a household, a non-financial business and the government, but no banks. They were omitted because macroeconomists thought of them as a simple “veil” between savers and borrowers, rather than profit-seeking firms that make loans opportunistically and may they affect the economy.
This perspective has changed, to put it mildly. Hyun Song Shin of Princeton University has shown that banks’ internal risk models make them take more and more risk as asset prices rise, for instance. Yale’s John Geanakoplos has long argued that in fact small changes in the willingness of creditors to lend against a given asset can have large effects on that asset’s price. Easy lending terms allow speculators with little cash to bid up prices far above their fundamental value. If lenders become more conservative, these marginal buyers are forced out of the market, causing prices to tumble.
Realistically representing the financial sector would help solve the other big problem with mainstream macro models: that they are inherently stable unless disturbed from the outside. This feature is helpful when studying how an economy in “equilibrium” responds to things like a spike in the price of petrol, but it limits economists’ understanding of why economies expand and contract in the absence of such external shocks. Highly leveraged financial firms with portfolios of risky assets are bound to upend an economy every so often. Having banks in models would generate shocks from within the system.
The world’s big central banks are interested in these new ideas, although staff economists are reluctant to abandon existing “industry-standard” models. If any central bank is likely to experiment, however, it is the European Central Bank, thanks to its “two-pillar approach” to assessing the risks of price stability. The ECB pays as much attention to “monetary analysis”, which includes things like bank lending and money creation, as to “economic analysis”, which is more concerned with things like inflation and joblessness.

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