Economics Research on Systemic Risks
by eriposte

Via Lambert at Correntewire and Yves at Naked Capitalism, here’s an interesting opinion paper by a bunch of academics from the US and Europe:

The Financial Crisis and the Systemic Failure of Academic Economics

Here’s the abstract:

The economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its dimensions once it started to unfold. In our view, this lack of understanding is due to a misallocation of research efforts in economics. We trace the deeper roots of this failure to the profession’s insistence on constructing models that, by design, disregard the key elements driving outcomes in real-world 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.

This paper is definitely worth reading. One of the most interesting aspects touched upon by the paper is this, and I have to say I agree with this:

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;⁴ even as they saw individuals and businesses build a financial system based on their work. There are a number of possible explanations for this failure to warn the public. One is a “lack of understanding” explanation – the researchers did not know the models were fragile. We find 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. A second, more likely 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. In our view, economists, as with all scientists, have an ethical responsibility to communicate the limitations of their models and the potential misuses of their research. Currently, there is no ethical code for professional economic scientists. There should be one.

I’m highlighting the last point in bold primarily because I routinely see economists – especially of the conservative variety – talk authoritatively about stuff without bothering to acknowledge real world situations that run counter to their assumptions.

One point that came to mind upon reading the paper is this – what are the principal sources of funding for economics research? How much of it is funded by universities themselves versus government agencies versus the private sector [especially the financial sector]? How much of the research is dependent on the cooperation of entities [whether government or industry] that have a stake in the implications of the findings? I don’t have a good idea and am trying to find out – because the quality and depth of research is often dictated by who is funding it and what their expectations are. For example, if some research on derivatives, financial models and what not, is funded by companies in the private sector that have an interest in using the research or models, then it becomes more likely that the models might tend to gloss over realities.

"… this failure to warn the public. One is a “lack of understanding” explanation – the researchers did not know the models were fragile. We find 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. A second, more likely explanation, is that they did not consider it their job to warn the public."

The most recent literature provides us with examples of blindness against the upcoming storm that seem odd in retrospect. For example, in their analysis of the risk management implications of CDOs, Krahnen [2005] and Krahnen and Wilde [2006] mention the possibility of an increase of ‘systemic risk.’ But, they conclude that this aspect should not be the concern of the banks engaged in the CDO market, because it is the governments’ responsibility to provide costless insurance against a system-wide crash. On the more theoretical side, a recent and prominent strand of literature essentially argues that consumers and investors are too risk averse because of their memory of the [improbable] event of the Great Depression [e.g., Cogley and Sargent, 2008]. Much of the motivation for economics as an academic discipline stems from the desire to explain phenomena like unemployment, boom and bust cycles, and financial crises, but the dominant theoretical model excludes many of the aspects of the economy that will likely lead to a crisis. Confining theoretical models to ‘normal’ times without consideration of such defects might seem contradictory to the focus that the average taxpayer would expect of the scientists on his payroll.

But it took people in the financial institutions to put these tools to use with such disastrous results. I spent my morning after returning from a vacation poring over the AIG-FP/Joseph Cassano story [see economic rape… below]. It’s a horrible story of a small business unit in an AAA rated Company finding a way to rake in billions selling insurance that was essentially unsecured, using the unregulated Derivatives Markets [created by the team of Gramm and Gramm, originally for Enron]. The CFTC chief that followed Wendy Gramm, Brooksley Born rattled sabres all over Washington trying to point out the dangers of these complex financial instruments called credit default swaps, but was opposed at every turn by Alan Greenspan and other government financial advisors. So, true enough that the government allowed these tools for fraud to continue, but the financial industry jumped at the chance to use them to create the largest insurance fraud ever conceived – one that created and plundered the housing bubble/sub-prime mortgage crisis. Nowhere did any of the academic economic models include projections for what would happen as this cancer grew and grew.  The economists stayed with the clean stuff – using models with unrealistic, built-in stability that made them useless in the nasty world of real-life economic practice. Even after the Enron people used these unregulated markets to create energy bubbles in California that almost bankrupted the State, no economists saw these same dynamics as part of the escalating gas prices that were [now obviously] part of an "oil bubble" – probably created by the very Enron Traders who had just moved on to lucrative jobs in new digs.

The implicit view behind standard models is that markets and economies are inherently stable and that they only temporarily get off track. The majority of economists thus failed to warn policy makers about the threatening system crisis and ignored the work of those who did. Ironically, as the crisis has unfolded, economists have had no choice but to abandon their standard models and to produce hand-waving common-sense remedies. Common-sense advice, although useful, is a poor substitute for an underlying model that can provide much-needed guidance for developing policy and regulation. 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”.

THIS IS WHERE THE DEAD TEACH THE LIVING HOW TO LIVE