What can modern macro tell us about financial crisis?

[ssendam]

If you've been following the financial news, you know some interesting things have been happening lately: the housing bubble, credit markets freezing up, hedge funds getting margin calls, the Fed intervening, etc. Now, the old-school economists (Keynes, Friedman, Hayek, etc) thought about this kind of stuff a lot... but what does "modern" macroeconomics have to say about this? As far as I can tell, RBC, DGSE, general equilibrium etc models don't even have banks in them... so can they tell us anything about what's happening right now?

[Weary]

They dont consider uncertainty, as opposed to risk, that we are currently facing. And also put little emphasis on out of equilibrium situations. So, well, nothing.

[manet]

This thread and its lack of responses further solidified my views on modern macroeconomic studies. :whistle: :rolleyes: :hmm:

[pevdoki1]

It's somewhat amusing that every non-economics person that I talk to is extremely concerned with the current world situation, and they all ask me "what does economics tell us about it?" or "what's going to happen to the U.S. economy in the next couple of years?"

 

All I can do is shrug my shoulders, since I really have no idea. From the layman/armchair perspective, it looks to me like the world is going to hell, but I don't know how to write a nice analysis proof for it :)

[iugi85]

I am not sure I understood your question correctly. But if you mean theoretical models that incorporate banks, and the possibility of their crisis, you can look at (and the references therein) :

Diamond and Dybvig (1983), “Bank Runs, Deposit Insurance, and Liquidity"

Abreu, Dilip, and Markus Brunnermeier (2003): “Bubbles and Crashes,”

and all the literature about global games, for example

Angeletos, George-Marios, Christian Hellwig, and Alessandro Pavan (2006): “Signaling in a Global Game: Coordination and Policy Traps,”

[econphilomath]

This thread and its lack of responses further solidified my views on modern macroeconomic studies. :whistle: :rolleyes: :hmm:

 

That is a bit harsh given this is a forum for people who are applying to PhD programs not academic economist that might give you an answer such as Ricardo Caballero.

 

Plus anyone who followed the last Davos could tell its not just "modern macroeconomic models", just about everyone has no idea what the hell was going on. If you guys want to get an entertaining opinion, check out Nouriel Roubini's blog(Its my homepage, no not TM), not this forum.

 

 

As far as I can tell, RBC, DGSE, general equilibrium etc models don't even have banks in them... so can they tell us anything about what's happening right now?

 

You model what you want to understand. DSGE, RBC or any model for that matter are made because they are intended to isolate certain things and not to explain everything.

 

Its unfair to judge macroeconomics by what it doesn't explain given it is a science founded less than 100 years ago. We have learned a lot, and we need to advance our knowledge in that area. So now we have a topic to research! Quit dissing macro and get to work...

[Valhalla]

"Unique Equilibrium in a model of self fulfilling currency attacks"

Stephen Morris, Hyun Song Shi, AER Vol.88. No.3 (June 98) pp 587-597

"Bank runs as an equilibrium Phenomenon"

Andrew Postlewaite, Xavier Vives, JPE vol. 95, No.3 (June 1978) pp 485-491

 

"The twin crisis: The Causes of Banking and Balance-of-payments Problems"

Graciela L. Kaminsky, Carmen Reinhart, AER, Vol 89, No3, (June 1999) pp 473-500

 

"Liquidity banks and markets"

Douglas W. Diamond, JPE, Vol 105, No 5 (Oct 1997), pp 928-956

 

"Bank runs, Deposit Insurance and Liquidity"

Douglas W. Diamond, Philip H Dybvig, JPE, Vol 91, No 3 (June 1983) pp 401-419

 

"Bank runs as an equilibrium phenomenon"

Andrew Postlewaite, Xavier Vives, JPE, Vol 95, No3 (June 1987) pp 485-491

 

AND SO ON....

 

"That's all I have to say about it"

Forest Gump

[Valhalla]

They dont consider uncertainty...

 

???? What??? Of course they do... what do you think does the S in DSGE stands for?

 

It's really ridiculous. What do you think macro-guys do the whole day?

[ssendam]

I am not sure I understood your question correctly. But if you mean theoretical models that incorporate banks, and the possibility of their crisis, you can look at (and the references therein) :

Diamond and Dybvig (1983), “Bank Runs, Deposit Insurance, and Liquidity"

Abreu, Dilip, and Markus Brunnermeier (2003): “Bubbles and Crashes,”

and all the literature about global games, for example

Angeletos, George-Marios, Christian Hellwig, and Alessandro Pavan (2006): “Signaling in a Global Game: Coordination and Policy Traps,”

 

"Unique Equilibrium in a model of self fulfilling currency attacks"

Stephen Morris, Hyun Song Shi, AER Vol.88. No.3 (June 98) pp 587-597

 

"Bank runs as an equilibrium Phenomenon"

Andrew Postlewaite, Xavier Vives, JPE vol. 95, No.3 (June 1978) pp 485-491

 

"The twin crisis: The Causes of Banking and Balance-of-payments Problems"

Graciela L. Kaminsky, Carmen Reinhart, AER, Vol 89, No3, (June 1999) pp 473-500

 

"Liquidity banks and markets"

Douglas W. Diamond, JPE, Vol 105, No 5 (Oct 1997), pp 928-956

 

"Bank runs, Deposit Insurance and Liquidity"

Douglas W. Diamond, Philip H Dybvig, JPE, Vol 91, No 3 (June 1983) pp 401-419

 

"Bank runs as an equilibrium phenomenon"

Andrew Postlewaite, Xavier Vives, JPE, Vol 95, No3 (June 1987) pp 485-491

 

None of those papers are "macro" models, that is, trying to model the entire economy with agents, production, infinite periods, etc.

[Weary]

???? What??? Of course they do... what do you think does the S in DSGE stands for?

 

It's really ridiculous. What do you think macro-guys do the whole day?

 

Uhm...Silly? :) Here is yahoo answering your question: What is the difference between Risk and Uncertainty? - Yahoo! Answers An attempt to address issues of uncertainty is developing robust control theory in relation to macroeconomics (model uncertainty related works, due mainly to Hansen and Sargent) but it is not a part of mainstream yet.

[pevdoki1]

 

It's really ridiculous. What do you think macro-guys do the whole day?

 

Here is your answer: http://www.princeton.edu/~pkrugman/interstellar.pdf

 

:grad:

[sonicskat]

Considering modern macro is extremely micro-based, I'd be weary of bashing the field since anymore it is an extension of micro theory.

 

Also, don't assume that all Macro is is just dynamic growth models. What about dynamic contracting? Couldn't this theory explain the high rate of foreclosures? why people would rather declare bankruptcy than pay the mortgage?

 

Also, the thing with macro is that the models are soooo sensitive to your assumptions. Backing up to growth model stuff, go check out manuelli's notes and go through a couple questions at the end of each section. Slight modifications in your assumptions can drastically change your result.

 

So while Macro does not have the nicely wrapped conclusions that empirical micro might have in many cases, the complexities regarding every institution that affects everybody's decision in every market in this issue is extremely complex to say the least.

[buckykatt]

Do we really need a macroeconomist to tell us that letting fraud and questionable business practices run rampant is bad for the economy?

[Weary]

We need one to quantify the effect. But he is not coming heh

[Ipsofacto]

What is more interesting, in my limited perspective, is that macro can tell me what the government or the Central Bank should do to go back to the Long Term Equilibrium. However, it would not tell me what to do in order to safeguard my money. For example, if my savings happens to be in stock, the market is sinking, inflation high, expectation low, economic theory does not tell me how to save my money out of a bad market. But it is the question you will be asked most often when people learn that you are an economist (or economist wanna-be).

[kuejai]

One interesting I see is the situation is somewhat similar to the Asian Crisis. It started with housing market and high deficit. (Of course, Asian Crisis was a lot messier)

[econphilomath]

One interesting I see is the situation is somewhat similar to the Asian Crisis. It started with housing market and high deficit. (Of course, Asian Crisis was a lot messier)

 

They both have banking crisis but besides that, I don't see much similarities. I don't see a major balance of payments / currency problem escalating in the US!

Could you elaborate on that? Maybe you have in mind a) excess liquidity leads to over investment is crappy assets? b) LTCM and now Bear Stears? :hmm:I'm probably missing something.

 

Things that are different in my mind:

-Asian/Russian Crisis starts in emerging markets while now its in the financial capital of the world.

 

-Main factor leading to miss pricing and weird incentives were due to fixed exchange rate in Asia (starting with the Thailand baht) that lead to accumulation of foreign denominated debt. Crappy regulation and herding behavior + speculators and add to the mix lots of short term debt to make everyone run out the door at the same time and there you have it!

 

I like Chang & Velasco's papers on the Asian crisis. Ricardo Caballero has some papers on how problems with financial intermediation lead to amplification of a crisis but I'm not sure if thats the case now.

 

It seems to me that the cause of the miss pricing and consecutive adjustment now has more to do with having the wrong ways of calculating the risk/uncertainty attached to ever more complicated financial instruments. Plus missing regulation, and an asset bubble Greenspan wimped out on bursting...:doh:

 

Also, the ramifications of this crisis might be very different to previous ones given the state of the world economy and the financial soundness of emerging markets worldwide stemming from the commodity boom. Who knows how that will play out...

 

Just random thoughts on the financial crisis. What do you guys think...

 

 

 

EDIT: almost forgot, maybe modern macro doesn't already supply a model that explains it all but in contrast to the times of Keynes and Hayak, we now have better tools to affront the challenges that these events present us as economists. While I feel some of the posters are disheartened by modern macro, I feel very motivated by the prospects of rolling up my sleeves and getting to work on understanding what is going on.

[kuejai]

Econphilomath,

The similarity is just a trigger(just a beginning of the crisis). It started with housing market slump, which causes other hidden problems to magnify. The Asian crisis was then largely due to fixed exchange, CORRUPTION, and overpricing asset.

For the US, I think it's going to be gov deficit. Then, this will put financial institutions into testing whether they are operate effectively. Otherwise, we might see a major financial crash soon. (so far i just heard of lay off, but I don't think it's going to be that bad like Asian crisis)

[sonicskat]

One of the big issues right now (according to my prof from the Fed) is the fear of contagious bank runs. Bear Sterns was an example of a bank run where the illiquidity of their assets led to their demise. This is quite different than the Asian crisis which was a currency crisis.

 

However, the moral hazard issues that plagued Asia are definitely part of what has lead to the Bear Sterns breakdown. With a family member being a mortgage broker, I was amazed that in the past 5 years people can get loans with low initial interest rates without even having proof of a job. So while on the news you hear lots of things about the subprime mortgage and whatnot (which is going on), this whole debacle of regulation was also happening as well.

 

Check out the Diamond-Dygbig model that will explain exactly what happened with Bear Sterns.

[MooMooCow]

Modern macro is based on the representative agent model. While this masks itself as a micro-based model it actually not a mathematically valid way of aggregating preferences or multi-person interactions. Thus macro can tell us little about any macroeconomics crisis.

[econphilomath]

double post sorry ....

[econphilomath]

One of the big issues right now (according to my prof from the Fed) is the fear of contagious bank runs. Bear Sterns was an example of a bank run where the illiquidity of their assets led to their demise. This is quite different than the Asian crisis which was a currency crisis.

 

However, the moral hazard issues that plagued Asia are definitely part of what has lead to the Bear Sterns breakdown. With a family member being a mortgage broker, I was amazed that in the past 5 years people can get loans with low initial interest rates without even having proof of a job. So while on the news you hear lots of things about the subprime mortgage and whatnot (which is going on), this whole debacle of regulation was also happening as well.

 

Check out the Diamond-Dygbig model that will explain exactly what happened with Bear Sterns.

 

Ahh but what is the policy recommendation of DD? Government backing of loans, which of course is what Bernanke is doing bailing banks out to get everyone else to calm down and not run on the rest of the banks.

 

Plus, banks in DD are fundamentally fragile and go bust by definition if they get run against, independent of how good or bad their investments were. I'm not sure Bear Sterns was in that situation, run yes, innocent,...hmmm

 

Econphilomath,

The similarity is just a trigger(just a beginning of the crisis). It started with housing market slump, which causes other hidden problems to magnify. The Asian crisis was then largely due to fixed exchange, CORRUPTION, and overpricing asset.

There was always the debate if it was more fundamentals vs self fulfiling crisis, as the main cause of the asian crisis. I don't remember which side won that debate but I tend to lean towards the important role of panics and multiple equilibria which is bad for now.

 

Thing is, we learned from past crisis already in the sense developing countries have much less short term debt, they have flexible exchange rates, larger reserves and generally better macro policies. Problem is this crisis will again test how much fundamentals matter in the mist of a panic. I mean, we are talking about the financial capital of the world here! Not some banana republic not paying its loans or something....

 

These are exciting times to be in the ivory tower for sure. Exciting to be in the pits too.

But poor Bernanke, he got it rough while Greenspan lite the match (or didn't blow it out actually) and ran off.

[italos]

''.....Inflation Targeting Central Banks have nothing to do with current financial instability.It is all fault of the financial markets and their structure that overestimate and overreact current event.....''Charles A. E. Goodhart, Round table discussion at the Royal Economic Society Annual Conference 2008, University of Warwick, March 17-19

[ssendam]

However, the moral hazard issues that plagued Asia are definitely part of what has lead to the Bear Sterns breakdown. With a family member being a mortgage broker, I was amazed that in the past 5 years people can get loans with low initial interest rates without even having proof of a job. So while on the news you hear lots of things about the subprime mortgage and whatnot (which is going on), this whole debacle of regulation was also happening as well.

 

Check out the Diamond-Dygbig model that will explain exactly what happened with Bear Sterns.

 

But how have we arrived at this state where we have to worry about bank runs in the first place? Is it just bad luck, or is it endogenous to the economy? The old macroeconomists tried to think about this, e.g. Mises/Hayek had the Austrian business cycle theory of how credit expansion leads to overinvestment. Hyman Minsky similarly thought that there were endogenous credit bubbles that led to booms and busts. None of these guys were mathematically rigorous, but when something is critical to the health of the economy (and the Fed seems to think it is), then you'd hope that we would have some theoretical understanding of how this happened.

[Valhalla]

developing countries have much less short term debt, they have flexible exchange rates, larger reserves and generally better macro policies...

 

Maybe I simply misunderstood this? Did you mean developed countries? Otherwise I don't understand why developING countries should have "better" (whatever this means exactly) macro policies - but I have to admit that I am not a macro guy.