– The Financial Crisis and the Systemic Failure of Academic Economics (click on the download button at top of page)

– Beyond DSGE Models: Toward an Empirically Based Macroeconomics

I think many central bankers took their eye off the ball fifteen years ago, buoyed by their success against inflation, and forgot about the credit cycles. Their main models didn’t have credit cycles (the RBNZ forecasting model didn’t even have a financial sector let alone room for credit cycles); the earlier literature by Bagehot, Marshall, Von Mises and Keynes was ignored as irrelevent; and the mantra than monetary economics concerned the way that the price, terms and conditions and the quantity of nominal debt contracts was replaced by an insistence that one only needed to target interest rates. The problem was not inflation targetting but the narrow version that ignored the role of credit that was implemented by many central banks. The misuse of the Phillips Curve by over-zealous central bankers may be the real fault. Hopefully they have learnt their lesson; it is just a pity that the warning signals about the problems of excessive credit creation that were highlighted by people such as Borio and Lowe in the early 2000s (and written about at length prior to 1930) were ignored.

While the central banks are building gates on their barns now that the horses have bolted, the real question is whether they will have the gumption to close them when they are next needed in a few years time. I wouldn’t like to bet on it: two centuries of financial crises suggest otherwise.

Perhaps the best we can hope for is that the next generation will read Lombard St before they need it rather than after (and when doing so read Chapter 8 on central bank governance) ….and that they manage to control inflation. After all, in New Zealand we have now had the price level increase by 50 percent since 1992, despite the legislated goal of the Bank to achieve stability in the general level of prices.

When the collective acts on its components: economic crisis autocatalytic percolation

Impact of the topology of global macroeconomic network on the spreading of economic crises

Backbone of complex networks of corporations: The flow of control

Some may ask why I’m posting materials related to complex network theory? Well, some of the research coming out of this area have been able to give reasonable explanation of crisis (ie, it is only a toy model and may not be the exact or true underlying mechanism that drives such process).

Systemic Risk in a Unifying Framework for Cascading Processes on Networks

There are many publications out there on the specific application of network theory to economic/financial networks, where the above paper is a general application of network theory to a varieties of domains.

Good point – I said above that I was rolling with my interpretation because I didn’t find what was being said particularly clear.

Specifically, the main thing for me is “why” they think credit aggregates are important. I see two channels for them mattering:

1) They are relevant for inflation outcomes, and so should be used when setting monetary policy.
2) They are relevant in terms of financial stability, and should be looked at in terms of this broader framework and its separate set of instruments.

Without separating the two, I feel like inflation targeting gets attacked for no reason. After all – it is future inflation that is being targeted, so the current framework should take into account any information credit aggregates provide regarding to inflation outcomes. It doesn’t change “pure inflation targeting” in any way.

This argument sort of assumes that other financial stability instruments (regulations, capital requirements) are insufficient to achieve financial stability and that ‘core’ monetary policy can be used to influence ‘financial stability.

Yar, but it is a static counterfactual rather than dynamic. The implicit assumptions with any cross-country comparison that does this must be that:

1) The countries have some type of equivalence,
2) The relative performance coming into the crisis is irrelevant.

I have enough trouble with the first issue, but the second is an absolute killer. The counterfactual HAS to include the full set of consequences of policy – not just the benefits during a credit crisis.

“But globally, current account balances have to sum to zero”

That is also a fine point. I suspect they would say “we need the relative sizes to be lower, there is just too much debt man”.

It amazes me that the economics profession studies “present biased” behaviour, and yet is unable to take this into consideration when trying to do economic analysis. It makes me nervous about my own belief that people will find mechanisms to “precommit” to the optimal solution in the face of time inconsistency.