Friday, May 4, 2012

An insight into why economic models missed the financial crisis and don't explain the recovery

In his Washington Post blog, Ezra Klein examines the assumptions underlying macro-econometric models.  He discovers that the models essentially ignore the financial sector and as a result are incapable of distinguishing between the impact on the economy from the loss of wealth from the dot-com bubble bursting and a housing meltdown.

“The macroeconometric models used by the Fed -- like those used by the Congressional Budget Office, the White House and others -- had at best a very rudimentary financial sector built into them.” So “they treated the housing collapse as if it were merely dot-com bust 2.0.” And that’s still the case today, [Peter Orszag] says... 
”You’re probably wondering why economists would leave leverage out of our models,” adds Jared Bernstein. “Good question. It’s because we’ve historically viewed financial markets as basically an intermediate input in the economic process, distributing savings to their most productive sources. [Alan] Greenspan added the assumption the hyper-rationality would lead market participants to self-regulate.”...
Actually, I wonder why economists don't highlight that a major assumption in their models is the virtual exclusion of the financial sector.

If they did, it might raise some doubts as to whether to trust the results of these models after the financial sector crashes.
Bernstein also brings up another difference between a housing crisis and an stock-market bubble:

When a bubble bursts, it mops up more quickly because of the difference between “mark-to-market” in an equity bubble and “extend-and-pretend” in a debt-financed housing bubble. The fact that your pet rock shares go from valuations of $1,000 on Friday to $1 on Monday rips the bandaid off in a way you don’t get when banks can inflate for months on end their balance-sheet value of non-performing loans.
Please re-read the highlighted text on the difference between a bubble bursting in an area of the financial market where there is transparency (the stock market) and an area of the financial market where there is opacity (banks).

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