The Dahlem report on the financial crisis and the failure of academic economics

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The Dahlem report on the financial crisis and the
failure of academic economics

• Katarina Juselius
• Department of Economics
• University 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 on toxic 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
  legal safety 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 between politics, 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 100
  in 1968 to over 500 in 1978
• 175 corporations had registered lobbyists in
  1971. In 1982 they were 2500.
• 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 burst
  government 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 for people 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 market hypothesis) 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 real economy, 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 markets will 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 off track. 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 abandon their 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 recessions by Richard Koo (2008, 2010).

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Criticism cont. Unrealistic assumptions of
financial models

• Many of the financial economists who developed
  the theoretical models upon 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 were fragile. 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 resources are 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
  view obviously 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 replication is not applicable 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 theoretical foundations 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 assumptions unrealistic
outcomes

• Many macroeconomic models are built upon the twin
  assumptions of rational 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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What about empirical economics? Confronting
theories with historical data (time series)

• Two different empirical approaches
• Taking a theory model to the data (theory-first)
• Specific-to General Econometrics
• Data are silenced by numerous prior restrictions
  imposed on the data from the outset
• Scientifically sound only if the assumed theory
  model is true.
• Unless the economists has omnipotence the
  empirical analysis is an illustration of prior
  beliefs. (The scientific illusion of empirical
  economics, Summers, 1994)
• Taking the data to the theory models
  (reality-first)
• General-to-Specific Econometrics
• Data are allowed to speak freely at the
  background of many theories.
• Postulate There are many economic models but one
  economic reality The economic reality is
  structured by the available data to create
  confidence intervals within which empirically
  relevant models should fall.
• It is more important to learn how and where we
  are wrong (Popper).

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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 in particular 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 currently popular 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 empirically sound.
• 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 how strong 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. Massive violation 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 also
  harvested 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 spite of 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 useful policy 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 US
  journals 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 power over 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 US approach.
• 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. The methodological 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 the representative 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 Richer
  and 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 financial
  catastrophe. 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 Aftermath of 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/