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

1. The Dahlem report on the financial crisis and the failure of academic economics Katarina Juselius Department of Economics University of Copenahgen

2. 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

3. Someilluminatingstatistics: the cost of the recent financialcrisis 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

4. The effectoninequality • 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.

5. The tax rates by the super richdecreaseddramatically in thisperiod

7. The effect of the recent crisison 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

9. The governmentregulatory and supervisory system has becomeinefficientorcorrupt • 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 (Cheyney’s old firm) without raising any question about it.

10. Howcouldthishappen? Has USA become a bananarepublic? • 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.

11. Big Business becomes a powerfulpoliticalactor • All this paid off: The Congress embarked on a shift in policy arguing that excessive regulation had become a serious curb on growth. • Carter’s 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.

12. The richest’sshare of National income has increasedstarting from Carter administration

13. Justifyingtax-cutswitheconomic 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.

14. Justifyingderegulationwitheconomic 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.

15. 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 profession’s focus on models that, by design, disregard key elements, including heterogeneity of decision rules, revisions of forecasting strategies, and changes in the social context—that 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.

16. Critisismcont. The relianceonstationaryequilibria • 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).

17. Criticismcont. Unrealisticassumptions 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.

18. Whythingswent 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).

19. Whythingswent so wrongcont. Evaluation of structuredproducts for creditrisk • 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.

20. Whythingswent so wrongcont. 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.

21. Have thingsimproved? • 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.”

22. Unrealisticeconomicassumptions – unrealisticoutcomes • 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

23. Whataboutempiricaleconomics? Confrontingtheorieswithhistorical 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).

24. Whichare 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.

25. Policy implications: The Dahlem groupemphasizedthat: • 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 today’s practice. • Such support should be assessed based on stringent mathematical/statistical testing of assumptions. Massive violation of this principle.

26. Needed: A change in the academicincentive 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.

27. 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.

28. Concludingremarks • 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.

29. 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): Fool’s 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.

30. 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 Japan’s 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/