Why are Economies Unstable?
Hub Co-Leader: Prof Roger E. A. Farmer Follow @farmerrf
Roger E. A. Farmer is the Co-Leader for Rebuild Macro’s Instability Hub and Research Director at NIESR, London. He is also a Professor of Economics at the University of Warwick in the UK and a Distinguished Professor of Economics at UCLA. Roger is widely known as a world-leading economist and former Senior Houblon-Norman Fellow at the Bank of England. He has published numerous scholarly articles in leading academic journals, as well as books that have been translated into Chinese, Italian, Vietnamese and Hungarian.
Hub Co-Leader: Jean-Philippe Bouchaud
Jean-Philippe Bouchaudis the Co-Leader for Rebuild Macro’s Instability Hub. After studying at the French Lycée of London, he graduated from the Ecole Normale Supérieure in Paris, where he also obtained his PhD in physics. He was then appointed by the CNRS until 1992. After a year spent in the Cavendish Laboratory (Cambridge), he joined the Service de Physique de l’Etat Condensé (CEA-Saclay), where he worked on the dynamics of glassy systems and on granular media.
Over the last decade, we have seen that economies are prone to sudden contractions and then may grow more slowly than expected. This is the clearest example to suggest that economies may not be stable. Yet macroeconomic models are usually constructed such that optimal decision making by private agents guide the economy back to stability.
Different modelling approaches
In the mainstream model, business cycles arise because a representative agent optimally responds to unforeseeable technology shocks. Price rigidities may slow this process down, and so the role of government becomes one of reducing these rigidities as much as possible. This is in contrast to earlier work on business cycles, e.g. Keynes (1936).
Alternative models with internal or endogenous business cycles exhibiting some of the persistent outcomes we observe in the real world have been developed. For example, representative agent models suggest different policy responses than conventional models, and would have significant differences in macroeconomic outcomes. Given mainstream models have been inconsistent with observation, why have alternative modelling techniques received so little attention?
Modern macroeconomic models are grounded in optimal decision making by representative agents to ensure that the model is internally consistent. However, the dependence on microfoundations has been drawn into question. For example, describing people as perfectly planning out precisely the rest of their lives is against psychological and sociological evidence.
The necessity of microfoundations has been questioned, as perhaps this prevents the use of empirical aggregate level relationships from being included in macroeconomic models. Conversely, including a greater diversity of preferences, endowments, or complex decision making might be a step in the right direction. Agent based modelling, as opposed to the standard utility maximising framework, might be useful here – but decision making would still need to be consistent.
Credit or financial cycles
Credit cycles are documented going back to the 1700s. They are typically longer than business cycles and have greater consequences. During Breton Woods there were zero systemic crises in the seventeen leading economies, but since it collapsed, there has been twenty-five. Why this increase in crises?
Mainstream macroeconomic models failed to include a meaningful financial sector. New models include credit frictions which can amplify temporary deviations. However, this is not the same as where financial sector decisions influence the allocation of resources. Financial instability and default costs have shown that there are long-term consequences which are inconsistent with the assumption of stability.
Secular stagnation and balance sheets
Another set of ideas is around the concept of secular stagnation: low levels of investment may be keeping output low and even reducing growth rates. This is consistent with the low rates of return and levels of investment. Excess savings that are not used for real investment result in lower real interest rates which have consequences for the allocation of capital both into asset prices and across borders. The outcomes have potential consequences for financial and economic stability.
This brings us back to why the low levels of investment persist at a time of great innovation. Some argue this depends on levels of debt from earlier expansions creating ‘balance sheet’ effects. Others suggest that the returns to those who make technological advances are so great that they are not recycled into effective demand. Earlier stock-flow consistent macroeconomic models may provide new insights.