Macro Models And Black Swan Risk: Financial Market Conundrum

Macro Models And Black Swan Risk

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The devastating crisis in 2008 provided clear evidence that mainstream macroeconomic models ignored risks associated with debt and the financial cycle and were rendered moot when the crisis hit. In recognizing these endogenous risks, an investment framework should integrate financial cycle and macroeconomic risk.

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Why has more not been done to develop an integrated approach to macroeconomic and financial market risks (is this a "slip between the cup and the lip”)? This perplexing question became far more important following the deregulation and liberalization of financial markets in the 1980s, yet theory continues to lag events. Liberalization awakened the sleeping giant of finance, as witnessed through the explosive growth in credit and asset prices (serial boom-bust cycles) that ultimately culminated in the 2007-2009 crisis.

It sometimes seems as if macroeconomics and financial markets exist on different planes. For example, macroeconomic models are designed to ignore credit, money and the financial cycle. This shortcoming has proven quite expensive for investors, who have twice lost 40% of their portfolios since 2000. In the months leading up to the crisis in 2008, mainstream macroeconomic models (IMF, Fed, etc.) continued to reflect positive growth forecasts. And so the Queen of England asked, “Why did no one see it coming?” This innocent question acknowledged the reality that the Emperor (aka, Macro Model) has no clothes.

Macroeconomics has been characterized as a "methodological mono-culture," meaning that to be recognized or published in mainstream economic journals one must abide by certain principles, regardless of whether or not these correspond with the real world. One must drink the Kool-Aid, so to speak. Interestingly, Paul Romer, who wrote in Advanced Macroeconomics, 3rd Edition, that “Incorporating money in models of growth would only obscure the analysis,” has since written a rather provocative article entitled “The Trouble with Macroeconomics.” In it, the first line in the abstract reads: “For more than three decades, macroeconomics has gone backward.”

The financial regulators also failed. They bought into the Economics 101 illusion and wholeheartedly supported deregulation and liberalization, without in any way understanding what makes finance different. The regulators focused on institution-specific risk missing the forest for the trees. What they missed were fallacies of composition. Namely, that an action initiated by one institution (the trees, where the regulators were focused) may not generate systemic consequences, but if initiated by many (the forest, where the regulators were not focused), may be devastating. Unfortunately, based on Neoliberal Economics 101 ideology, the regulators were asleep at the switch as the crisis approached in 2008. And even today, with all the attention paid to macro-prudential risk, etc., there is good reason to be skeptical that things will be all that different in the next crisis.

What is badly needed today is a new macro-financial approach that incorporates the financial cycle, credit and money. As I discuss elsewhere, positive feedbacks between credit growth and asset prices can generate boom-bust cycles that in general do not end well. Fortunately, some have advanced these arguments. For example Richard Werner has been writing extensively about this topic, for example, in an article entitled “Towards a New Research Program on “Banking and the Economy.”

I agree with Werner and others, including Steve Keen and Dirk Bezemer that banks create credit and thus money, and that there is an important distinction to be drawn between the creation of credit to support productive capital versus its creation to support financial asset prices. The former fuels growth in GDP and is, in general, sustainable. It exists in a roughly one-to-one relationship with GDP growth. However, the creation of credit to support asset prices has vastly different implications. It generates asset price inflation and capital gains, but ultimately is a zero-sum game. For every individual who generates a capital gain someone else must pay the difference, and this process results in the build-up of leverage. From a macroeconomic perspective, financial asset price appreciation is not a free lunch, given that no productive activity has occurred. Creation of excessive amounts of credit (as documented in the chart below by Dirk Bezemer, contribute to rising debt/GDP ratios, which ultimately are unsustainable and eventually unwind (Jeremy Grantham and GMO have written extensively about the history of bubbles).

Source: Dirk Bezemer (2012) and Federal Reserve Flow of Funds

By John M. Balder, read the full article here by Advisor Perspectives

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