Macro Models and Black Swan Risk: Financial Market Conundrum
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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.
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.”