Book Reviews, Economics

The New Economics Of Liquidity And Financial Frictions [Book Review]

Review: The New Economics Of Liquidity And Financial Frictions By David Adler, by The Finance Professionals’ Post

The New Economics of Liquidity and Financial Frictions is a book about a new branch of economics that is largely a synthesis of macro and finance. In many ways, it is a radical departure from the older, frictionless approach still prevalent in economic textbooks and most of academia. This book provides a new understanding and approach to asset pricing, risk measurement and management, central banking policy, and the overall working of today’s economy, including questions of financial stability.

The financial crisis caused an intellectual crisis in economics. Not only were conventional models and risk metrics unable to anticipate the crash, but they also had trouble grappling with it and its consequences long after it occurred.

The New Economics of Liquidity and Financial Frictions is a book about a new branch of economics that has emerged since the crisis, though work on the subject began far earlier. This new field is largely a synthesis of macro and finance. A friction is an impediment, obstruction, or constraint that prevents markets and economies from working smoothly. A crippled financial sector and lack of liquidity are critically important frictions. The field’s emphasis is on the frictions posed by both a credit boom and a credit bust. Frictions provide a new framework for viewing the economy.

The goal of the book is to convey to practitioners this modern economics, which in many ways is a radical departure from the older, frictionless approach still prevalent in economics textbooks and most of academia. It presents the many new models in this area, the intellectual history behind their development, and their strengths and limitations. But the insights offered by the new field are hardly just academic. The New Economics of Liquidity and Financial Frictions provides a new understanding and approach to asset pricing, risk measurement and management, central banking policy, and the overall working of today’s economy, including questions of financial stability. Importantly, this new field is also driving regulation, with key new systemic risk measures now enshrined in Basel III.

Marrying Macro and Finance

Though practitioners and the public may be astonished to learn it, mainstream macroeconomic models lack a financial sector. There are no banks. Moreover, these models formally rule out catastrophic outcomes for the economy. Hence, when the crisis occurred, central banks, to the degree they relied on the most advanced macro models of the day, known as dynamic stochastic general equilibrium (DSGE) models, lacked a roadmap for what was to come.

Chapter 1 explores the intellectual origins of this strange modeling pathway. There are both intellectual and practical justifications for these models’ oversights. In the canonical theories of economics, finance is just a “veil” over real activity. Moreover, most of the models were developed in the post–World War II era in the United States—a time of great financial stability, when systemic financial crises were not a pressing concern.

The first chapter also profiles the work of early economists who took a different approach: Irving Fisher, John Maynard Keynes, and, more recently, Hyman Minsky. Newer macro models—including that of Bernanke, Gilchrist, and Gertler—formalize some of the insights of these older economists, most notably those of Irving Fisher.

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The New Economics of Liquidity and Financial Frictions – Description

The New Economics of Liquidity and Financial Frictions by David Adler

The New Economics of Liquidity and Financial Frictions is a book about a new branch of economics that is largely a synthesis of macro and finance. In many ways, it is a radical departure from the older, frictionless approach still prevalent in economic textbooks and most of academia. This book provides a new understanding and approach to asset pricing, risk measurement and management, central banking policy, and the overall working of today’s economy, including questions of financial stability.

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The New Economics of Liquidity and Financial Frictions - Review

Foreword

There cannot, in short, be a more insignificant thing, in the economy of society, than money.

—John Stuart Mill, Principles of Political Economy with Some of Their Applications to Social Philosophy

Feathers and Bricks

What would you think of a scientific field that assumes away one of the most basic aspects of the natural world that the field hopes to understand? Probably not much. Yet modern macroeconomics, astonishingly, assumes away the existence of money, banking, and the rest of the financial sector. As a consequence, macroeconomists didn’t foresee the great crash of 2008–2009 because the crash originated in the financial sector, which, according to their predominant model, didn’t exist. That’s not as crazy as it sounds. Newtonian and Einsteinian physics assume that there’s no friction. Even Galileo, when he compared the speed of dropped feathers and bricks a half century before Newton, knew to allow for friction and concluded that gravity acted equally on the two objects, the difference in their rate of fall being due entirely to resistance from the atmosphere.

A World without Friction

Why assume away something important, such as friction? Simplifying nature in this way creates a base case from which deviations can be measured and explained. Feathers encounter considerable friction. If we didn’t know the rate at which bricks fall, we wouldn’t be able to measure the greater impact of friction on feathers. Likewise, the economy is full of frictions: Search and transaction costs prevent markets from being perfect or close to perfect, while decisions are made using incomplete information by people who are less than wholly rational.

Macroeconomics, then, has evolved in a way that tends to set aside such distractions as money and the financial sector because it seeks to explain, in as simple terms as possible, the functioning of the real economy—the economy of factories, trucks, natural resources, labor contracts, patents, and so forth. The financial economy, from this viewpoint, is a sideshow involving claims on the real economy—stocks, bonds, commodity futures contracts—but not the real economic goods themselves.

Is Money a Veil or a Lubricant?

In this sense, “money is a veil,” as Arthur Pigou famously said, channeling John Stuart Mill as quoted in the epigraph. (Pigou 1949; Mill 1848, moreover, The New Economics of Liquidity and Financial Frictions was channeling David Hume’s 1752 essay “Of Money.” Money as a veil is a core concept of classical economics, but it has leaked through to Keynesian economics too and is basically correct: Without money and finance, we’d have a barter economy that would suffer from huge friction costs but that would not otherwise be very different.) In other words, the use of money as a medium of exchange obscures the real economic phenomena beneath. If that is the case, let’s remove the veil and study the real economy.

But financial institutions and instruments do exist, creating and trading them makes up a significant fraction of total economic activity, and they need to be explained and understood. They are best understood as a form of infrastructure, without which the rest of the economy would struggle to function.

- Bud Haslett, CFA

The New Economics Of Liquidity And Financial Frictions [Book Review]

The New Economics of Liquidity and Financial Frictions by David Adler