That the world economy received a “shock” when US government policy reversed itself in September 2008 and permitted Lehman Brothers to fail: what kind of an explanation is that? Meanwhile, the shadow banking industry, a vast collection of financial intermediaries that included money market funds, investment banks, insurance companies and hedge funds, had grown to cycle and recycle (at some sort of rate of interest) the enormous sums of money that accrued as the world globalized. Finally, there was uncertainty, doubt, fear, and then panic. These institutions began running on each other. No depositors standing on sidewalks – only traders staring dumbfounded at comport screens.
Only a theory beats another theory, of course. And the theory of financial crises has a long, long way to go before it is expressed in carefully-reasoned models and mapped into the rest of what we think we know about the behavior of the world economy.
This is all in preparation for a new book coming out – misunderstanding financial crises – which I have now preordered.
There appears to be a vein of distaste for DSGE models in this post, and this is the one bit I don’t agree with. Economic methodology isn’t about having a “single model” – we try to be as reductionist as we can, but we have to instead rely on a suite of models that provide a narrative of different causal mechanisms that exist when people interact. DSGE models are incredibly valuable, but they were never made to explain shocks – or to illustrate what happens when the shock is sufficiently large that we may not return to our previous equilibrium.
I’m also a bit confused about why the author appears to be hinting that modern economists don’t think that way – I clearly remember being taught about stability, multiple pareto ranked equilibrium, and the issue of bank runs. I also remember being taught all this as part of “New Keynesian economics” and being told that DSGE models were in themselves only a subsection of the models we should look at when trying to understand what is going on around us. And this was in 2005.
However what seems to me critical in avoiding future crises is to understand why leverage increased (and was allowed to increase) in the first place, rather than the specifics of how it unravelled. As I suggested here, we may find more revealing answers by thinking about the political economy of how banks influenced regulations and regulators, rather than by thinking about the dynamics of networks.
While also accepting that the analysis of complex networks with multiple equilibrium is useful. Why are economists so determined to create simple models rather than just making a full complex system that can be calibrated t fit data? Easy – because these complex systems don’t tell us anything about causal mechanisms, and we need to understand causal mechanisms in order to determine what policies “make sense”. It is a co-operative venture between multiple forms of modelling, not a competitive venture IMO.
Anyway, I’m looking forward to the book – and I’m currently reading the prequel, slapped by the invisible hand