The Queen of England criticizes economic models

It seems the Queen of England visited the London School of Economics a couple of years ago and listened to some discussion of the general equilibrium models used by central banks in their efforts to understand and manage entire economies. According to economist Thomas Lux, she astutely commented on the peculiarity that these models do not even include a financial sector, even though the financial industry has expanded markedly over past decades and clearly now plays an enormous role in any developed economy.

I'm hoping someone can tell me more about this anecdote, perhaps if they were present at the meeting. Lux's comments are listed in his response to an email sent out to various scientists by Dirk Helbing, seeking their views on the primary shortcomings of contemporary economic theory. The responses from those scientists hit on a number of themes - replacing equilibrium models with more general models able to include instabilities, going beyond the representative agent approximation, and so on. And, as the Queen rightly noted, acknowledging that the financial sector exists.

European Central Bank's Trechet on post-crisis economics

Italian physicist Luciano Pietronero recently pointed me to an address given by Jean Claude Trichet, president of the European Central Bank. It was titled Reflections on the nature of monetary policy: non-standard measures and finance theory and given at the ECB's 2010 Central Banking Conference which brings together central bankers from around the world.

In the speech, Trechet aimed to identify "some main lessons to be learned from the crisis regarding economic analysis." After talking a little about monetary policy and inflation targets, Trichet got to his main points about the shortcomings of current finance theory.

When the crisis came, the serious limitations of existing economic and financial models immediately became apparent. Arbitrage broke down in many market segments, as markets froze and market participants were gripped by panic. Macro models failed to predict the crisis and seemed incapable of explaining what was happening to the economy in a convincing manner. As a policy-maker during the crisis, I found the available models of limited help. In fact, I would go further: in the face of the crisis, we felt abandoned by conventional tools.

In the absence of clear guidance from existing analytical frameworks, policy-makers had to place particular reliance on our experience. Judgement and experience inevitably played a key role... In exercising judgement, we were helped by one area of the economic literature: historical analysis. Historical studies of specific crisis episodes highlighted potential problems which could be expected. And they pointed to possible solutions. Most importantly, the historical record told us what mistakes to avoid.

But relying on judgement inevitably involves risks. We need macroeconomic and financial models to discipline and structure our judgemental analysis. How should such models evolve? The key lesson I would draw from our experience is the danger of relying on a single tool, methodology or paradigm. Policy-makers need to have input from various theoretical perspectives and from a range of empirical approaches. Open debate and a diversity of views must be cultivated – admittedly not always an easy task in an institution such as a central bank. We do not need to throw out our DSGE and asset-pricing models: rather we need to develop complementary tools to improve the robustness of our overall framework.

This is a somewhat formal and wordy expression of a sentiment expressed quite beautifully two years ago by journalist Will Hutton of The Observer in London:

Economics is a discipline for quiet times. The profession, it turns out, ...has no grip on understanding how the abnormal grows out of the normal and what happens next, its practitioners like weather forecasters who don't understand storms.

In other words, when markets are relatively stable, unstressed and calm, the basic equilibrium framework of economic theory gives a not-too-misleading picture. But in any episode of slightly unusual dynamics the standard theories give very little insight. The trouble is, of course, that unusual episodes are actually not so unusual. I haven't yet tried to count of the number of financial and economic crises described in Charles Kindleberger's masterpiece Manias, Panis and Crashes: A History of Financial Crises, but it is surely a few hundred over the past two centuries (and this doesn't even touch on the short term tumults that frequently hit markets on short time scales).

Trichet went on to describe the kinds of ideas he thinks finance theory needs to turn to if it is going to improve:

First, we have to think about how to characterise the homo economicus at the heart of any model. The atomistic, optimising agents underlying existing models do not capture behaviour during a crisis period. We need to deal better with heterogeneity across agents and the interaction among those heterogeneous agents. We need to entertain alternative motivations for economic choices. Behavioural economics draws on psychology to explain decisions made in crisis circumstances. Agent-based modelling dispenses with the optimisation assumption and allows for more complex interactions between agents. Such approaches are worthy of our attention.

Second, we may need to consider a richer characterisation of expectation formation. Rational expectations theory has brought macroeconomic analysis a long way over the past four decades. But there is a clear need to re-examine this assumption. Very encouraging work is under way on new concepts, such as learning and rational inattention.

Third, we need to better integrate the crucial role played by the financial system into our macroeconomic models. One approach appends a financial sector to the existing framework, but more far-reaching amendments may be required. In particular, dealing with the non-linear behaviour of the financial system will be important, so as to account for the pro-cyclical build up of leverage and vulnerabilities.

In this context, I would very much welcome inspiration from other disciplines: physics, engineering, psychology, biology. Bringing experts from these fields together with economists and central bankers is potentially very creative and valuable. Scientists have developed sophisticated tools for analysing complex dynamic systems in a rigorous way. These models have proved helpful in understanding many important but complex phenomena: epidemics, weather patterns, crowd psychology, magnetic fields. Such tools have been applied by market practitioners to portfolio management decisions, on occasion with some success. I am hopeful that central banks can also benefit from these insights in developing tools to analyse financial markets and monetary policy transmission.

So, four things: get past the idea that economic agents must be rational and optimising, take note of human learning, include financial markets in the models used by central banks, and bring economic theories up to date with advanced ideas coming from physics and other sciences linked to the study of complex systems. This quite an extraordinary statement made by the president of the European Central Bank to central bankers from around the world. Were they listening?

On Trechet's speech, physicist Jean-Philippe Bouchaud had the following interesting comment:

Those not steeped in economic theory may not realize how revolutionary Mr. Trichet’s challenge is. Economics has traditionally been closely focused on developing a core set of ideas that are very different from those that Mr. Trichet champions above. It is truly remarkable for the president of the ECB to suggest such a radical departure from the traditional canon of economics, and it is a reflection of the seriousness of the crisis and the magnitude of the loss of confidence in existing tools. And it is not just Mr. Trichet who is asking these questions -- senior policymakers in finance and economic ministries, central banks, and regulatory agencies across the EU, as well as in the US and other countries are asking similar questions.

Stick A Fork In Me!

I'm done, done, DONE with grading for the semester. Now there's nothing left to do but wait for the complaints. Ah well - that I can deal with.

For a reward, I spent the night spent reading an anthology of short stories titled Strange Brew by P.N. Elrod (author of the Vampire Files). It includes stories by some of my favorites, including Jim Butcher, Patricia Briggs, and Charlaine Harris, among others (what can I say - I'm a big fantasy/sci-fi nerd).

On the biking side, there's been nothing but rain for the last few days, so I went to the gym to use the exercise bike for about 40 minutes. It's a poor substitute for having wheels on the road, but my 50 miler (the Angel Ride) is only 11 days ahead, so it's better than nothing.

Enough goofing off - back to research.

Update: The rain stopped, so I got in another 26 miler. I rode like a circus bear on a bike, but I was still within a minute of my best time, so I'll take it. The good news is that I seem to be able to handle at least that distance at a pretty good pace even on an off day. So, with a bit more work, I should be able to do the 50 if I dial back a bit. It won't be pretty, but it's a ride, not a race.

The Physics of Finance

In the spring of 2009, in the wake of the recent financial crisis, economists gathered at a conference in Dahlem, Germany for five days of discussion on the economic modeling of financial markets. After the meeting, the group issued a joint statement on the economic profession's failure to either see the financial crisis coming or to judge its ultimate severity. The lack of understanding, they suggested in the conference report, is due

“... to a mis-allocation of research efforts in economics. We trace the deeper roots of this failure to the profession’s insistence on constructing models that, by design, disregard the key elements driving outcomes in real-world markets. The economics profession has failed in communicating the limitations, weaknesses, and even dangers of its preferred models to the public.”

The full report makes good reading. Most importantly, it singles out the lack of realistic market dynamics as the primary failing of the standard models used by economists. These models assume that markets tend to a state of balance or equilibrium, and pay no attention to potential positive feed backs -- among asset prices, investors views, new regulations and so on -- which might drive markets far away from a state of balance. Realistic models would seek to capture such processes from the outset.

This aim of this blog is to cover and comment upon a wide range of new research -- much of it in physics, but some elsewhere - which is beginning to fill this gap. The idea is to accept that markets like most other natural systems have rich and complex internal dynamics. As with the weather, terrific storms can brew up out of blue skies through quite ordinary natural processes. If the equilibrium fixation of traditional economics has pushed the study of crises to one side - as the study of those exceptional events that occur when markets fail - the new perspective aims to understand how crises of many kinds emerge quite naturally from market processes. As any glance at history shows, they surely do, and quite routinely.

This work has been developing and growing more sophisticated since early evolutionary models of financial markets first developed in the mid 1990s at the Santa Fe Institute in New Mexico. It has come a long way since then, particularly in the past five years, and a growing number of economists and policy makers are beginning to take it very seriously. As just one example, Nature recently published a paper reviewing research on the stability of banking "ecosystems" - looking at problems that can arise in networks of banks -- which was co-authored by a mathematical ecologist, Robert May, along with an employee of the Bank of England, Andrew Haldane.

Old crude ideas about efficient markets and market equilibrium are rapidly being buried, good riddance, to be replaced by more realistic and useful ideas emerging from the physics of finance.

It's Time To Bring The Crop In

It's that time of the semester - exams are done, projects are in (with one exception) and it's grading time. Some highlights/low lights:

• My Student Managed Investment fund was a weak group, and they never seemed to "get with the program". As a result, they did a lot of the work for the end-of-semester presentation to our advisory board in the 11th hour.
  
• Having said that, they did a pretty good job in the presentation. Not as good as last year's group (that was probably my strongest group in the last 5 years), but good enough
• My Investments class did terribly on my final exam. On the one hand, it means that grades will be lower than expected. On the other, since grades will depend a lot on the curve, it allows me a lot of flexibility.
• I have THREE students that will be returning for my student-managed investment fund class next semester (they're three of the better ones, too). This makes my job a lot easier.
  

On non-job related things, I'm mostly trying to put in enough miles on my bike so that I'll be ready for the Hole In The Wall Gang Angel Ride. It's a relatively hilly 50 miler, and, while I'm pretty sure I can finish it, it'll be ugly. So, I'm trying to squeeze in a few more 25-30 milers in the next two weeks. It's a good cause (check out the link above.).

Unfortunately, yesterday involved a pretty hard 26 miler followed in short order by my 1 1/2 hour "Yoga For Stiff Guys" class (fairly strenuous yoga done in a heated room). BY the end of the day, I was beat to the bone.

Oh well - back to grading those last few student projects.

FMA Decisions Are Out!

I just heard from a coauthor - we got a paper accepted at the Denver FMA meeting in October. The idea resulted from taking an idea we'd been working on and applying it to another data set we had available.

It's funny - we submitted two papers: this one was an early version, and the other was pretty much finished. However, to be fair, the results on this one were more interesting. And since we'd already gotten one paper on the program, we were actually glad we got the second one rejected - doing two papers at a conference means there's less time for catching up with friends.

This tale of two papers reminds me of a piece I read a while back (unfortunately, I can't recall its title). It discussed how there's a trade-off in research between "newness" and "required rigor". In other words, if you're working on a topic that's been done to death (e.g. capital structure or dividend policy), you'll be asked to do robustness tests out the yazoo. On the other hand, if it's a more novel idea, there's a lower bar on the rigor side, because the "newness" factor gets you some slack on the rigor side. .

In general, however, the "rigor" bar has been ratcheting up for the last 20-30 years, regardless of the "newness" factor. To see this, realize that the average length of a Journal of Finance article in the early 80s was something like l6 pages - now it's more like 30-40. As further (anecdotal) evidence, a friend of mine had a paper published on long-run returns around some types of mergers in the Journal of Banking and Finance about 9 years back. They made him calculate the returns FIVE different ways.

In any event, to make a long story short, I'm hoping we got accepted at FMA because the reviewers though our paper was a good, new idea.

But it's probably because we got lucky.

But either way, we'll take it - see you in Denver!

Journal Of Undergraduate Research In Finance

There's a new journal out geared towards undergraduate research. It's called (appropriately), The Journal of Undergraduate Research In Finance. Here's it's description:

The Journal of Undergraduate Research in Finance publishes original work written exclusively by undergraduates. Accepted articles are largely the result of the highest quality senior or honors theses. Articles come from all areas of Finance, case studies and pedagogy. All articles are subject to blind review by faculty.

The JURF exists to encourage exceptional undergraduate students to pursue high quality research in Finance, to provide these students with an outlet for their research, and to prepare these students for success in graduate school or industry. To maintain a focus on contributions made by the students, faculty involvement is limited to the guidance typically given during the writing of a senior thesis. Initial submissions must be made while the author is an undergraduate student.

The JURF is published annually.

So, if you have a student who has done some good research and who might be looking for an outlet, have them send it in - the submission deadline for this year's edition is May 15. As an added inducement, the top three articles for this year's issue will be invited to the FMA meeting in Denver to present their research, and will be considered for the annual Mark J. Bertus prize (in the amount of $1,000).