Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles...

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Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global finance in the light of the global crisis April 10, 2008 Ping Chen China Center for Economic Research at Peking University, Beijing, China Center for New Political Economy at Fudan University, Shanghai, China [email protected]

Transcript of Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles...

Page 1: Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global.

Three Dimensions of Economic Crisis:Theoretical, Empirical, and Policy

Analysis in Business Cycles

Prepared for IDEAs Conference onRe-regulating global finance in the light of the global crisis

April 10, 2008

Ping ChenChina Center for Economic Research at

Peking University, Beijing, ChinaCenter for New Political Economy atFudan University, Shanghai, China

[email protected]

Page 2: Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global.

Nature of Business Cycles and Economic Crisis

• Exogenous school• Frisch (1933), Friedman & Schwartz(1963),• Lucas (1972), RBC, Black & Scholes (1973)• Endogenous school• Marx, Schumpeter, Hayek, von Mises, Keynes, Minsky,

• Natural experiments 》 The Great Depression (1929-41), Stock Market Crash (1987), Sub-Prime Crisis (2008-)

• Computational experiment 》 Discovery of deterministic color chaos (Chen 1996) > Endogenous nature

Page 3: Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global.

Operational Implications of Exogenous/Endogenous divide

• Exogenous forces 》 events driven by random walk or white noise 》 time series uncorrelated 》 history does not matter! 》 no internal/historical constraints to government policy!

• Endogenous forces 》 events driven by wavelets 》 time series highly correlated 》 history does matter! 》 strong internal/historical constraints to government policy!

Page 4: Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global.

Auto-Correlation Function for Deterministic & Stochastic Time Series

Page 5: Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global.

Different auto-correlations for Competing detrended time series

0 10 20 30 40 50-1

-0.5

0

0.5

1

AC

(n)

HPcLLcFDs

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Equilibrium Illusion created by First-Differencing (High Frequency Noise Amplifier 》 Whitening

Filter) in Econometric Analysis

• Frequency response for the FD filter• X(t) = FD[S(t)]=S(t+1)-S(t)

0 0.1 0.2 0.3 0.4 0.50

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4FD Whitening Filter

f

Fre

q R

esponse R

(f)

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Evidence of Strange Attractor in Stock Market Obtained by WGQ transform (Wigner transform + Gabor

space + Qian algorithm) Time-Varying Filter

-0.3

-0.2

-0.1

0

0.1

0.2

0.3

X(t

+T)

-0.3 -0.2 -0.1 0 0.1 0.2 0.3X(t)

FSPCOM Raw HP Cycles

-0.3

-0.2

-0.1

0

0.1

0.2

0.3

-0.3

X(t

+T)

-0.2 -0.1 0 0.1 0.2 0.3X(t)

FSPCOM Filtered HP Cycles

Page 8: Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global.

Stock Price Indexes (Standard & Poor 500)Fractal dimension = 2.5

Variance of color chaos = 69 %

-4

-2

0

2

4

1945 1955 1965

S(t

)

1975 1985 1995t

FSPCOM Original & Filtered Cycles (H=0.5)

SoSg

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Economic diagnosis:Exogenous(1973) vs. Endogenous events

1965 1970 1975 1980 1985 19900

5

10

15

20Pc History of FSPCOM HP Cycles

Pc

(yrs

)

Pc OilShock StockCrash

Page 10: Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global.

Noise-Driven Cycles ( Frisch 1933 ) vs. Harmonic Brownian Motion

( Unlenbeck & Orstein, 1930 )

• Wang & Unlenbeck (1945)

• Frisch model for American business cycles , which would be damped in 5-20 years ( Chen 1999,2004)!

Page 11: Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global.

Frisch model : Perpetual Motion Machine of Second Type ?

• Frisch was not the FIRST: G.E.Uhlenbeck and L.S. Ornstein, "On the Theory of Brownian Motion," Physical Review, 36(3), 823-841 (1930).

• Frisch’s Informal conference paper: R. Frisch, “Propagation Problems and Impulse Problems in Dynamic Economics”, in Economic Essays in Honour of Gustav Cassel, George Allen & Unwin, London (1933).

• Frisch's promised paper, "Changing harmonics studied from the point of view of linear operators and erratic shocks," was advertised three times under the category "papers to appear in early issues" in Econometrica, including Issue No. 2, 3, and 4 of Volume I (April, July, and October 1933) but never appeared in Econometrica since 1934.

• Frisch never mentioned a word about his prize-winning model in his Nobel speech in 1969 (Frisch 1981).

Page 12: Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global.

The Principle of Large Numbersfor Positive Variables

More Micro Elements > Less Macro Fluctuations

(Independent fluctuations may cancel out each other)

• SN=X1+X2+ . . . . . . +XN

• Relative Deviation (RD) =

Page 13: Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global.

Observed Relative Deviation 》 Implied Numbers (Data Source: Fed. Reserve St. Louis)

Real Personal consumption : 0.15% (800,000)• Real GDP: 0.2 % (500,000)

• Real Private Investment: 1.2% (10,000)

• Dow Jones Industrial (1928-09) : 1.4% (9000)• S&P 500 Index (1947-2009) : 1.6% (5000)• NASDAQ (1971-2009): 2.0 % (3000)

• Texas Crude Oil Price (1978-2008): 5.3 % (400)

Page 14: Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global.

US Household & Firm Numbers in1980and Their Capability in Generating RD

• Realistic Number and Potential Relative Deviations

Micro-Agents Households Corporations* Public Companies

N 80.7(million) 2.9(million) 20,000

(%) 0.01 0.05 0.7

*Here, we count only those corporations with more than $100,000 in assets.

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Economic Implications from Principle of Large Numbers

• Household fluctuations contribute less than 10% of GDP fluctuations 》 weak “micro foundations” in business cycles

• Small firm fluctuations contribute only about a quarter of GDP fluctuations

• Only public companies and giant organizations may generate large fluctuations in investment, which is 6-10 times larger than GDP fluctuations 》 meso foundations of business cycles

Page 16: Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global.

Why Lucas is wrong about microfoundations and rational expectations?

• MISTAKE I. Lucas critique also applies to Lucas theory when relative prices move in pairs 》 creates arbitrage opportunity

• Under rational choice between leisure and work, there is arbitrage opportunity among mass

• Example: shock > wage DOWN > many workers choose leisure > leisure price UP > some workers choose work instead > cancel out the rational mass effect under “rational expectations”

• MISTAKE II. Lucas model of island economy with N agents 》 disguised model of representative agent 》 system degree of freedom =3 》 individual degree of freedom is 3/N ~ 0!

• Counter example: Ideal Gas in physics, each particle has 6 degree of freedom 》 system with N particle has 6N degree of freedom

• Conclusion: equilibrium illusion of self-stabilizing market is created by representative agent model in macro + FD whitening filter in econometrics

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Dan Gilligan, President of the PMA(Petroleum Marketers Association) on Oil Price Manipulated by Financial Giants

• Did Speculation Fuel Oil Price Swings?? (CBS 60 Minutes, 01/12/2009)• http://www.cwpma.org/Template.php?-p=HomeNewsPopup&-d=News&-r=52.0

• in 2000, Congress deregulated the futures market, granting exemptions for complicated derivative investments called oil swaps, as well as electronic trading on private exchanges.

• Volatility in price of oil per barrel within one year : $67↑ $147↓ $45 ; even jump $25 in one day!

• Changes in demand & supply less than 5% 》 Changes in price of oil larger than 100%

• In mid-June - end of Nov. 2008 , Congress investigation started > $70 billion speculative capital left future market 》 demand of oil dropped 5 %》 Price of oil dropped more than 75% to $100

• 60 % -70 % of oil contracts in future market controlled by speculative capital• In past 5 years , capital poured into oil market by Hedge Funds and Big Investment Banks: $13

billion ↑ $300 billions• Large players : Morgan Stanley, Goldman Sachs, Barclays, J.P. Morgan put hundred of

billions of dollars in oil future market , California pension fund. Harvard Endowment, and large institutional investors

Page 18: Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global.

Smith Theorem and Market Share Regulation

• Adam Smith Theorem: Division of labor is limited by market extent 》 danger of monopolistic competition

• Hidden hypothesis in efficient market (invisible hand) 》 unlimited market extent

• Real market 》 Limitation of market extent and players 》 Necessary of International anti-trust law not only for merge & acquisition but also for trading in financial market

• Disclose market positions in trading for big players

Page 19: Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global.

Policy Implications for Crisis Policy

• Traditional policy with “too big to fail”• Take over failed companies by a bigger firm, such as

Citigroup and Bank of America 》 prediction: Citigroup and Bank of America would become worse

• Better competition policy under Principle of Large Numbers

• Breaking up AIG, Citigroup into competing firms 》 improve chances of innovation and competition + diversify risk of wrong decision

• Examples: China broke up China Airline into several companies, Oligarchs in Russia

Page 20: Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global.

RD Behavior for Stochastic Models

• Random walk is damping over time• Brownian motion is exploding over time• Only the Birth-death process is stable in time >

resilient market of endogenous fluctuations

Order Brownian motion Birth-Death Random-Walk Mean )exp(~rt )exp(~rt t Variance }1){2exp(~

2

tert )1(~rtrtee t

RD )1(~2

2

2 t

tee

0

1~N t

1

Page 21: Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global.

Source of Financial Instability : Nonlinear Trend & Higher Moments in Birth-Death Process

• Option pricing model based on nonlinear birth-death process

• Stability condition :• Under stability: finite first & second

moment 》 Ito 》 construct arbitrage portfolio 》 Black-Scholes model

2 31 1 2 2 3 3

22 3

1 2 2 3 32

32 3

2 3 33

43

34

[( ) ( ) ( ) ] ( )

[ ( ) (3 2 ) ] ( )

[ (3 ) ] ( )

( )

fa a a a a a f t

t

a a a a a f t

a a a f t

a f t

2 31 1 2 2 3 3[( ) ( ) ( ) ] 0,a a a a a a

Page 22: Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global.

Crisis : Trend Collapse & Divergence of Higher Moments

TED Spread(3 )个月欧洲美元与美国国债的息差

0

50

100

150

200

250

2007-1

2007-2

2007-3

2007-4

2007-5

2007-6

2007-7

2007-8

2007-9

2007-10

2007-11

2007-12 200

8-1

2008-2

2008-3

2008-4

基点

Dow Jones Industrial in Great Depression

Page 23: Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global.

Policy Constraints during Crisis

• International coordination• Danger of trade protection, asymmetric investment, and

competitive devaluation

• Domestic constraints:• Expansionary monetary policy 》 danger of inflation,

devaluation, and capital flight• Expansionary fiscal policy 》 danger of new bad loans,

crowding out small & medium healthy firms

• Finding new source of growth 》 structural adjustment 》 green economy

Page 24: Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global.

References

• Coase, R. H. The Firm, the market, and the Law, University of Chicago Press, Chicago (1990), Coase, R. “Social Costs” (1960).

• Frisch, R. "Propagation Problems and Impulse Problems in Dynamic Economics," in Economic Essays in Honour of Gustav Cassel, George Allen & Unwin, London (1933).

• Friedman, M. “The Case for Flexible Exchange Rates,” in M. Friedman, Essays in Positive Economics, University of Chicago Press, Chicago (1953).

• Friedman, M. and A.J. Schwartz, Monetary History of United States, 1867-1960, Princeton University Press, NJ: Princeton (1963).

• Lucas, R.E. Jr. "Expectations and the Neutrality of Money," Journal of Economic Theory, 4, 103-124 (1972).

• Minsky, H.P. Stabilizing an Unstable Economy, Yale University Press, New Haven (1986).

Page 25: Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global.

References

• Chen, P. “Empirical and Theoretical Evidence of Economic Chaos,” System Dynamics Review, Vol. 4, No. 1-2, 81-108 (1988).

• Chen, P. “A Random Walk or Color Chaos on the Stock Market? - Time-Frequency Analysis of S&P Indexes,” Studies in Nonlinear Dynamics & Econometrics , 1(2), 87-103 (1996).

• Chen, P. “Microfoundations of Macroeconomic Fluctuations and the Laws of Probability Theory: the Principle of Large Numbers vs. Rational Expectations Arbitrage,” Journal of Economic Behavior & Organization, 49, 327-344 (2002).

• Chen, P. “Evolutionary Economic Dynamics: Persistent Business Cycles, Disruptive Technology, and the Trade-Off between Stability and Complexity,” in Kurt Dopfer ed., The Evolutionary Foundations of Economics, Chapter 15, pp.472-505, Cambridge University Press, Cambridge (2005).

• Chen, P. “Complexity of Transaction Costs and Evolution of Corporate Governance,” Kyoto Economic Review, 76(2), 139 - 153 (2007).

• Chen, P. “Equilibrium Illusion, Economic Complexity, and Evolutionary Foundation of Economic Analysis,” Evolutionary and Institutional Economics Review, 5(1), 81-127 (2008).

• Schrödinger, E. What is Life? Cambridge University Press, Cambridge (1948).