Financial sector in macro models

In the wake of The Crisis, which arguably got going in full force about a decade ago, there has been a lot of soul searching in macro academia over the role of the financial sector in the standards models.  It seems to be taken as a given, at least in some circles, that dismissing the financial sector as a mere veil delayed recognition of The Crisis and then stymied reaction to it.

I don’t have anything to offer on what progress has been made during the past decade or how much that has reduced the risk of a repeat.  My instinct is to be pessimistic on the old saw that humans won’t make the same mistake twice but will insist instead on making a brand new one.  The current clamor for financial deregulation to unleash animal spirits and “get the economy going again”, with unemployment below 4 1/2%, makes me grumpy.

But away from that, I would like to toss out an idea for your consideration that will either resonate or not.  I can’t hope to demonstrate my case here, because I don’t have the knowledge base.

It seems possible that the problem was not mostly with the macro models’ failure to understand the importance of bank and shadow bank balance sheets, contagion, the role of the financial accelerator, etc.  The problem was that many of us failed to identify the shock itself, which was a pretty big failure, but not one that can necessarily be put down to macro models.  Maybe Robert Lucas and Alan Greenspan lulled us into complacency, but it was through the spirit of the era, rather than through equations or lack of them.

I have mentioned this before, but I remember a colleague back at the old shop handing me an academic study going over the CDO Tower of Doom and the threat it posed to the economy. I also remember asking myself, how important could that be, compared with say, guessing what the Fed’s next move might be?  The study made such a little dent in my thinking that I cannot even remember its title. What I do remember is regretting not jumping all over it.

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In contrast, take a look at this very prescient and wonderfully unhedged piece of research from Jonathan Wilmot, published in August 2007, coming up on a decade ago.

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Generously ignore the excessive emphasis on the risk of a sudden stop of international capital flows, which was common (e.g. Roubini) and ended up being sorely misplaced.  The problem was not that the supply of capital to the US was cut off, but that the demand for it evaporated, which is definitely a separate discussion. The proof is that the dollar spiked.

Focus instead on Wilmot’s emphasis on forced deleveraging and the risk that posed to real economic activity.   That ended up being extremely prescient. And for those with the wits to take it seriously and in real time, the presumed absence of a fully developed financial sector in the standard macro models was probably not really the issue.  Some guys were able to see this coming, despite it.

For another example of such guys, read or watch The Big Short. Focus on the scene where Brad Pitt explains to the greedy short sellers that they ought not be too happy, because the economy was about to melt and cause a ton of human misery. He did not get that from paleo, hydraulic, new or post Keynesianism, nor from classical or market monetarism.  But he had it, and without the advantage of hindsight.