Comments on:

“The Financial Crisis and the Systemic Failure of Academic Economics”

Carl-Johan Dalgaard

DIIS , June 7, 2011

• Full disclosure: I don’t work in the field of macro that Katarina is criticizing

• I do share with Katarina a concern with this branch of macro

• But its no fun if I agree …

A couple of things worth bearing in mind at the outset

• The financial sector has a socially useful role to play: intermediate between savers and investors

• Fascilitates the growth process (entry/exit of firms)• That’s why growth theorists have been preoccupied with it

for decades

This process does not always work smoothly:

• Financial crisis has happened repeatedly in the past: Great Depression, Japan late 1980s/1990s, Sweden 1991, Asian Financial Crisis 1997 (Reinhart/Rogoff; Kindleberger and many others)

Average outcomes from Financial Crisis. Source: Reinhart & Rogoff, 2008. The aftermath of Financial Crisis.

• But as of early 2000s the ”mainstream” model (e.g., Woodford, 2003) of BC (Basically the AD/AS model, Benigno, 2009 ) did not reserve any particular role for financial intermediaries … why?

• The classical account of the GD: Friedman/Schwartz. Collapse of money supply (lower money multiplier), leading to lower economic activity and deflation

• Hence, the perception was the such crisis could be resolved by decisive action of the FED (plus deposit insurance). The source of the crisis in Asia did not seem to be relevant to economies like the US.

• FC’s have been studied, and lessons have found their way into textbook models (especially Great Depression) …

• So what’s ”new”?

• One critical factor: The rise of the ”shadow banking sector”. Banks and financial service companies were gradually allowed to integrate

• Why? Until 1980s commercial banks (in US) were not allowed to pay interest on demand deposits

Large depositors demanded alternatives; inflation in the 1970s important motivator

By 1990s business were out of deposits and into short run securities; usage accelerated during late 90s early 00’. Higher yields than deposits

• This market was uninsured and unregulated.• Economists did not appreciate its importance in the payment

system as a whole, thus its macro importance.

• So why didn’t politicians regulate the ”shadow banking sector”?

• An unholy alliance designed to benefit the rich and the politicians themselves (via campaign contributions)? Perhaps.

• Another reason: Growth and jobs.

• The financial sector was a big part of the growth revivial of the 1990s in the US (Bosworth and Triplett)

• Finance is global; political coordination failure.

In sum:• Financial crisis has happened (many times) before. Academic

economists thought they knew how to deal with them• Key novel element was however the changing nature of the

payment system, assigning a greater role to short term securities in the business sector

• That’s why a classical bank run of the 1930s did not have to happen, and yet the financial crisis became ”real”

• Technological change (computers, internet) probably contributed to the global integration of financial markets and thereby to contagion. This too was new, and probably underappreciated

• A flurry of interest in integrating financial intermediaries into macro-models in response (e.g., Woodford, 2010, JEP). ”Business as usual” (cf. Great D. and Stagflation)

• With hindsight bubbles were certainly unfolding: In the the housing market, and in the stock market. When they burst they aggravated the situation and contributed to the credit crunch

• Why didn’t people (academic economists, say) voice concerns?

• Lots of work (2000s) trying to see if the developments could be motivated by changes in the ”fundamental value” (e.g., Hall, Prescott and others).

• These ”explanations” could have been submitted to empirical tests. But nobody with interest in the field seems to have attempted to do so in a serious way …

• All theory depends on assumptions which are not quite true. That is what makes it theory. The art of successful theorizing is to make the inevitable simplifying assumptions in such a way that the final results are not very sensitive.' A "crucial" assumption is one on which the conclusions do depend sensitively, and it is important that crucial assumptions be reasonably realistic. When the results of a theory seem to flow specifically from a special crucial assumption, then if the assumption is dubious, the results are suspect. (R. Solow, 1956)

• No doubt rational expectations (RE) and the representative agent (RA) are unrealistic. But were they crucial? RE does not rule out bubbles…if they are not crucial, then Occam’s razor rules

• Did researchers not model financial intermediation because they didn’t know how to do without e.g. RA? Hard to believe; see growth literature.