Stability and Fragility: Where do we Go from Here?

1. Stability and Fragility: Where do we Go from Here? Herbert Gintis Santa Fe Institute Central European University Institute for New Economic Thinking (INET) November 2012

2. Financial Regulation is Based on Ideology, not Science Alan Greenspan, Chairman of the Federal Reserve of the United States from 1987 to 2006, statement to the House Committee on Oversight and Government Reform (October 2008): “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.” Alan Greenspan

3. The Common Stages of Financial Crisis My understanding is based on a new historical dataset for 14 countries from 1870 to 2008, analyzed Schularick and Taylor (American Economic Review, 2012) Credit growth is a powerful predictor of financial crises. Bank leverage increases rapidly on the upswing, so the financial sector becomes more vulnerable to shocks. Financial crises are credit booms gone wrong. This is basically the Hyman Minsky/Charles Kindleberger model: long periods of prosperity drive the conservative players out of controlling positions in finance and government. Only a solid foundation of economic theory can prevent future occurrences.

4. Sovereign Debt Crisis My understanding is based on a new historical dataset for 70 countries over the past two centuries, analyzed by Reinhart and Rogoff (American Economic Review, 2011). External debt surges are an antecedent to banking crises. Banking crises often precede or accompany sovereign debt crises. Public borrowing surges ahead of external sovereign default, and a country’s inability to sustain debt service is a “public secret” for reasons that are incompletely understood.

5. Current Financial Crisis The keyword of the recent financial crisis is contagion. from housing bubble to widespread US financial contraction to widespread employment and demand contraction to undermining world financial markets including the European sovereign debt crisis.

6. Contemporary Macroeconomics Contemporary macroeconomics cannot explain financial crises because the financial sector is not part of the standard macroeconomic models (dynamic stochastic general equilibrium and Keynesian), and coordination problems and multi-agent interaction cannot be represented in these models.

7. Freshwater Macroeconomics The most influential contemporary macroeconomic family of models (DSGE---dynamic stochastic general equilibrium---associated with Robert Lucas and the Chicago/Freshwater school) use highly aggregated representative agent models of the economy with one consumer, one firm, and in which all markets clear instantaneously. These models are not dynamic and they do not depict multiple interacting markets. They were developed to deal with government spending, inflation, and unemployment, not financial fragility.

8. Freshwater Macroeconomics:We Cannot Predict Financial Crises Rational expectations predicts that crises cannot be predicted, by definition. Robert Lucas, in the Economist (June 2009) says: “One thing we are not going to have, now or ever, is a set of models that forecasts sudden falls in the value of financial assets… Robert Lucas [This] has been known for more than 40 years and is one of the main implications of the efficient-market hypothesis (EMH).

9. Freshwater Macroeconomics:We Cannot Predict Financial Crises “The main lesson we should take away from the efficient markets hypothesis for policymaking purposes is the futility of trying to deal with crises and recessions by finding central bankers and regulators who can identify and puncture bubbles. If these people exist, we will not be able to afford them…” The problem, however, is not to predict crises or puncture bubbles, but to develop regulatory controls that minimize the probability of dislocations without reducing the efficiency of the financial sector.

10. Keynesian Macroeconomic Theory The minority position in macroeconomic theory, the Keynesian model (espoused by Paul Krugman, George Akerlof, Robert Shiller, and many others) assumes one good with two uses, consumption and investment. and two prices: the wage rate and the interest rate. The wage rate is rigid downwards because workers will not accept wage cuts, and the interest rate does not clear the savings/loans market because of liquidity preference.

11. Neo-Keynesian Theory: Fragility is Due to Irrationality Prominent Keynesian economists George Akerlof and Bradley Schiller’s Animal Spirits (Princeton, 2009) has become the rallying-cry for the reassertion of the importance of government regulation of the financial sector. George Akerlof

12. Neo-Keynesian Theory: Fragility is Due to Irrationality They write: “if we thought that people were totally rational… we too would believe that government should play little role in the regulation of financial markets, and perhaps even in determining the level of aggregate demand.” Robert Shiller

13. What we Know from Economic Theory Yet there is nothing in economic theory, by which I mean standard neoclassical microeconomics, and no empirical evidence, that markets with fully rational agents are intrinsically robust in the face of shocks. Nor is there any evidence that the central actors in the financial sector have been in any way irrational. How do we explain this curious situation, where respected economists make assertions with no basis in economic theory whatever? I will go back to the roots of contemporary economic theory to explore this issue.

14. What is General Equilibrium? There is one generally accepted model of the large-scale behavior of the market economy, known as Walrasian general equilibrium. The Swiss economist Léon Walras created this theory in 1874-1877 in his Elements of Pure Economics Léon Walras, 1834-1910

15. What is General Equilibrium? The Walrasian economy consists of households and firms. Firms buy or rent the services of inputs at given market prices, combine them to produce outputs which they sell at given market prices to the households.

16. What is General Equilibrium? Inputs include labor, capital goods (rented), raw materials, and the outputs of other firms (purchased). Inputs, as well as shares in the net profit of the firms, are owned by the households, and form their wealth. In each period, households buy the output of the various firms, some of which they consume, and some of which they add to their stock of wealth.

17. What is General Equilibrium? The Walrasian economy is in equilibrium when prices are set so that supply = demand for each good in the economy.

18. What is General Equilibrium? In the period 1952-1954, Kenneth Arrow and Gerard Debreu showed that with plausible assumptions, there exists a set of equilibrium (market clearing) prices. Gerard Debreu, 1921-2004 Kenneth Arrow, 1921-

19. The Quest for Stability The question of stability of the Walrasian economy was a central research focus in the years immediately following the existence proofs. The models of Arrow et al. assumed that out of equilibrium, there is a system of common prices shared by all agents, the time rate of change of prices being a function of aggregate excess demand. So when a good is in excess demand, its price increases, and when it is in excess supply, its price decreases. The problem is that this must happen in all markets simultaneously.

20. The Quest for Stability But who changes the prices? It cannot be individual agents, because there is one price for each good in the whole economy! Arrow et al. assumed that the price system was controlled by a mythical “auctioneer” (commisaire-priseur in French) acting outside the economy to update prices in the current period on the basis of the current pattern of excess demand, using a process of “tâtonnement,” as was first suggested by Walras himself.

21. Walras’ Auctioneer The auctioneer, before any buying and selling takes place, 1. calls out a set of prices, 2. asks firms and households say how much they want to buy and sell at these prices, 3. calculates the excess demand or excess supply for each sector, 4. adjusts the prices to bring the markets closer to equilibrium, • Then back to 1, until all markets are in equilibrium. • Only then is production and trade permitted, at the specified market-clearing prices.

22. The Quest for Stability Even if this project had been successful, the result would have been of doubtful value, as the tâtonnement process is purely fanciful. However, it was not successful. The quest for a general stability theorem was derailed by Herbert Scarf''s (1960) simple examples of unstable Walrasian equilibria.

23. The Quest for Stability General equilibrium theorists in the early 1970's harbored some expectation that plausible restrictions on the shape of the excess demand functions might entail stability, but Sonnenschein (1973), Mantel (1974, 1976), and Debreu (1974) showed that aggregate excess demand functions can have virtually any shape at all. It follows that the tâtonnement process cannot generally be stable.

24. The Quest for Stability Surveying the state of the art some quarter century after Arrow and Debreu's seminal existence theorems, Franklin Fisher (1983) concluded that little progress had been made towards a plausible model of Walrasian market dynamics.

25. The Quest for Stability It is now more than another quarter century since Fisher's remarks, but it remains the case that the current literature offers us nothing systematic about the dynamics of decentralized competitive market economies. Given this situation, it is hardly surprising that economic theory has had difficulty in shedding light on the causes of financial crisis, and offers no advice on how to prevent future occurrences without reducing the effectiveness of the financial system.

26. Rethinking Macroeconomics My work, like many of my colleagues, returns to a study of the fully decentralized Walrasian model, but this time with the understanding that the market economy is a complex, dynamic, nonlinear system that must be modeled using novel analytical tools. The goal is a model of market dynamics that analytically specifies the conditions under which the system is robust, thus suggesting regulations that promote robustness without compromising efficiency and capacity to innovate.

27. A Decentralized Market System with Individual Production I have explored decentralized market economies in several publications (e.g., Gintis 2007, 2012a,b), using agent-based modeling techniques. I find that if we start with a random assignment of prices to each agent, the economy moves quickly to quasi-public prices, the latter being private prices with low relative standard error across agents, and in the long run, quasi-public prices move to general Walrasian quasi-equilibrium, which is a stationary distribution with near-market-clearing prices in almost all periods.

28. Private to Quasi-Public Prices

29. Quasi-Market Clearing

30. Fragility vs. Stability There is little doubt but that the above stability properties will extend to more complex decentralized market economies. However a system can be stable, yet extremely robust or, by contrast, extremely fragile in reaction to shocks. I find that in a fairly realistic model of a contemporary advanced economy, price bubbles occur rather frequently, although in the absence of a sophisticated financial sector, they do not produce large aggregate dislocations in labor and product markets.

31. Basic Assumptions My more realistic agent-based model (The Economic Journal, 2007) assumes that consumers must engage in price searches in each period; workers have a subjective reservation wage that they use to determine whether to accept a job offer; firms know their production costs, but not their demand curves, and hence must experiment and learn. There is a central bank and a tax-collecting authority, as well as a government sector that services unemployment insurance.

32. Basic Assumptions Workers periodically search for alternative job opportunities; firms maximize profits by experimentally varying their operating characteristics and copying the behavior of other firms that are more successful than themselves; both prices and quantities respond to conditions of excess supply or demand; all adjustment parameters are agent- and firm-specific, and evolve endogenously.

33. Adjustment Processes In each period: For each firm inventory growth leads to lowering of price a small amount, and excess demand leads to raising price a small amount. average sector profits > 0 leads to a single firm entering the sector, and average profits < 0 leads to a single firm going bankrupt. firms make limited searches for alternative employees, and workers make limited searches for alternative employers. agents revise their consumption, production, employment, and trading strategies by sampling the population, and imitating the strategies of others who appear to be relatively successful. all adjustment rates are endogenous

34. Adjustment Processes Because all players (firms and workers) adjust their behavior by imitating the successful, the economic dynamic is an evolutionary dynamic imitation leads to correlated errors, so the statistical independence of errors assumptions that plague traditional macroeconomic models are absent here: “fat tails” are the rule, and there are large excursions from equilibrium in the absence of macro-level shocks.

35. Main Results The dynamical system satisfies the complex systems counterpart to stability and uniqueness: excess supply in each sector; excess labor demand, as well as excess labor supply in each period; labor demand differs fromlabor supply by only a few percent; Prices are approximately equal to production costs; The wage rate in each sector is fairly stable, and wages are approximately equal across sectors. There is a considerable level of fluctuation in price and quantity series, even though there are no aggregate stochastic shocks to the system.

36. Price Stability with Excursions

37. Price Stability with Excursions

38. Excess Demand and Supply

39. Profits

40. Unemployment

41. Unemployment

42. Stability

43. Stability percent • The vertical axis shows percentage efficiency.

44. Stability

45. Conclusion Simple market exchange is robust to shocks, whereas economies with sophisticated institutions can exhibit considerable fragility. The fragility of sophisticated market competition exchange is based on endogenous random shocks and does not require exogenous shocks. Agent-based simulation models provide insights into the dynamic performance of market economies.