Macro economics: the final frontier M. R. Grasselli Mainstream Alternative approaches SFC models Conclusions Macro economics: the final frontier M. R. Grasselli Mathematics and Statistics - McMaster University and Fields Institute for Research in Mathematical Sciences Advances in Financial Mathematics, Paris, January 9, 2014
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Macroeconomics:
the finalfrontier
M. R. Grasselli
Mainstream
Alternativeapproaches
SFC models
Conclusions
Macro economics: the final frontier
M. R. Grasselli
Mathematics and Statistics - McMaster Universityand Fields Institute for Research in Mathematical Sciences
Advances in Financial Mathematics, Paris, January 9, 2014
Macroeconomics:
the finalfrontier
M. R. Grasselli
Mainstream
Alternativeapproaches
SFC models
Conclusions
A brief history of Macroeconomics
Classics (Smith, Ricardo, Marx): no distinction betweenmicro and macro, Say’s law, emphasis on long run.
Beginning of the 20th century (Wicksell, Fisher): naturalrate of interest, quantity theory of money.
Keynesian revolution (1936): shift to demand, fallacies ofcomposition, role of expectations, and much more!
Neoclassical synthesis - 1945 to 1970 (Hicks, Samuelson,Solow): Keynesian consensus.
Start of Macro Wars: Real Business Cycles versus NewKeynesian.
1990’s: impression of consensus around DSGE models, butwith different flavours.
Macroeconomics:
the finalfrontier
M. R. Grasselli
Mainstream
Alternativeapproaches
SFC models
Conclusions
Dynamic Stochastic General Equilibrium
Seeks to explain the aggregate economy using theoriesbased on strong microeconomic foundations.
Collective decisions of rational individuals over a range ofvariables for both present and future.
All variables are assumed to be simultaneously inequilibrium.
The only way the economy can be in disequilibrium at anypoint in time is through decisions based on wronginformation.
Money is neutral in its effect on real variables.
Largely ignores uncertainty by simply subtracting riskpremia from all risky returns and treat them as risk-free.
Macroeconomics:
the finalfrontier
M. R. Grasselli
Mainstream
Alternativeapproaches
SFC models
Conclusions
Really bad economics: hardcore (freshwater) DSGE
The strand of DSGE economists affiliated with RBCtheory made the following predictions after 2008:
1 Increases government borrowing would lead to higherinterest rates on government debt because of “crowdingout”.
2 Increases in the money supply would lead to inflation.3 Fiscal stimulus has zero effect in an ideal world and
negative effect in practice (because of decreasedconfidence).
Macroeconomics:
the finalfrontier
M. R. Grasselli
Mainstream
Alternativeapproaches
SFC models
Conclusions
Wrong prediction number 1
Figure: Government borrowing and interest rates.
Macroeconomics:
the finalfrontier
M. R. Grasselli
Mainstream
Alternativeapproaches
SFC models
Conclusions
Wrong prediction number 2
Figure: Monetary base and inflation.
Macroeconomics:
the finalfrontier
M. R. Grasselli
Mainstream
Alternativeapproaches
SFC models
Conclusions
Wrong prediction number 3
Figure: Fiscal tightening and GDP.
Macroeconomics:
the finalfrontier
M. R. Grasselli
Mainstream
Alternativeapproaches
SFC models
Conclusions
Better (but still bad) economics: soft core(saltwater) DSGE
The strand of DSGE economists affiliated with NewKeynesian theory got all these predictions right.
They did so by augmented DSGE with ‘imperfections’(wage stickiness, asymmetric information, imperfectcompetition, etc).
Still DSGE at core - analogous to adding epicycles toPtolemaic planetary system.
For example: “Ignoring the foreign component, or lookingat the world as a whole, the overall level of debt makes nodifference to aggregate net worth – one person’s liability isanother person’s asset.” (Paul Krugman and Gauti B.Eggertsson, 2010, pp. 2-3)
Macroeconomics:
the finalfrontier
M. R. Grasselli
Mainstream
Alternativeapproaches
SFC models
Conclusions
Finance in DSGE models
The financial sector merely serve as intermediarieschanneling savings from households to business.Banks provide indirect finance by borrowing short andlending long (business loans), thereby solving the problemof liquidity preferences (Diamond and Dybvig (1986)model).Financial market provide direct finance through shares,thereby introducing market prices and discipline.Financial Frictions (e.g borrowing constraints, marketliquidity) create persistence and amplification of realshocks (Bernanke and Gertler (1989), Kiyotaki and Moore(1997) models)See Brunnermeier and Sannikov (2013) for a recentcontribution to this strand of literature in light of thefinancial crisis, in particular in the context ofmacro-prudential regulation.
Macroeconomics:
the finalfrontier
M. R. Grasselli
Mainstream
Alternativeapproaches
SFC models
Conclusions
Frictions literature still missing the point
Turner 2013 observes that:
“Quantitative impacts suggested by the models were farsmaller than those empirically observed in real worldepisodes such as the Great Depression or the 2008 crisis”
“Most of the literature omits consideration ofbehaviourally driven ‘irrational’ cycles in asset prices”.
“the vast majority of the literature ignores the possibilitiesof credit extension to finance the purchase of alreadyexisting assets”.
“the dominant model remains one in which householdsavers make deposits in banks, which lend money toentrepreneurs/businesses to pursue ‘investment projects’.The reality of a world in which only a small proportion(e.g. 15%) of bank credit funds ‘new investment projects’has therefore been left largely unexplored.”
Macroeconomics:
the finalfrontier
M. R. Grasselli
Mainstream
Alternativeapproaches
SFC models
Conclusions
Turner (2013) slide
Macroeconomics:
the finalfrontier
M. R. Grasselli
Mainstream
Alternativeapproaches
SFC models
Conclusions
A parallel history of Macroeconomics
Classical 19th century monetarism (Bagehot, AllanYoung): role of banks in trade (Britain) and development(U.S.), central banking.
Several prominent disciples of Keynes (Kaldor, Robinson,Davidson) immediately rejected the Neoclassical synthesisas “bastardized Keynesianism”.
Flow of Funds accounting - 1952 (Copeland): alternativeto both Y = C + I + G + X −M (finals sales) andMV = PT (money transactions) by tracking exchanges ofboth goods and financial assets.
Grydaki and Bezemer (2013): growth of debt in the realsector.
Macroeconomics:
the finalfrontier
M. R. Grasselli
Mainstream
Alternativeapproaches
SFC models
Goodwin model
Keen model
Ponzi financing
Noise and StockPrices
Stabilizinggovernment
GreatModeration
The UltimateModel
Conclusions
Bank credit-to-GDP ratio in the U.S
Figure: Grydaki and Bezemer (2013)
Macroeconomics:
the finalfrontier
M. R. Grasselli
Mainstream
Alternativeapproaches
SFC models
Goodwin model
Keen model
Ponzi financing
Noise and StockPrices
Stabilizinggovernment
GreatModeration
The UltimateModel
Conclusions
Cumulative percentage point growth of excesscredit growth, 1952-2008
Figure: Grydaki and Bezemer (2013)
Macroeconomics:
the finalfrontier
M. R. Grasselli
Mainstream
Alternativeapproaches
SFC models
Goodwin model
Keen model
Ponzi financing
Noise and StockPrices
Stabilizinggovernment
GreatModeration
The UltimateModel
Conclusions
Excess credit growth moderated output volatilityduring, but not before the Great Moderation
Figure: Grydaki and Bezemer (2013)
Macroeconomics:
the finalfrontier
M. R. Grasselli
Mainstream
Alternativeapproaches
SFC models
Goodwin model
Keen model
Ponzi financing
Noise and StockPrices
Stabilizinggovernment
GreatModeration
The UltimateModel
Conclusions
Example 8: strongly moderated oscillations
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
λ
0
500
1000
1500
2000
2500
3000
3500
Y
0
20
40
60
80
100
120
140
160
180
d
0
2
4
6
8
10
12p
0 10 20 30 40 50 60 70 80 90 1000.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
time
ω
ω0 = 0.9, λ
0 = 0.91, d
0 = 0.1, p
0 = 0.01, Y
0 = 100, κ’(π
eq) = 20
ωλYdp
Macroeconomics:
the finalfrontier
M. R. Grasselli
Mainstream
Alternativeapproaches
SFC models
Goodwin model
Keen model
Ponzi financing
Noise and StockPrices
Stabilizinggovernment
GreatModeration
The UltimateModel
Conclusions
Example 9 (cont): Shilnikov bifurcation
0.450.5
0.550.6
0.650.7
0.750.8
0.850.9 0.7
0.75
0.8
0.85
0.9
0.95
1
0
2
4
6
8
10
12
λ
ω0 = 0.9, λ
0 = 0.91, d
0 = 0.1, p
0 = 0.01, Y
0 = 100, κ’(π
eq) = 20
ω
d
Macroeconomics:
the finalfrontier
M. R. Grasselli
Mainstream
Alternativeapproaches
SFC models
Goodwin model
Keen model
Ponzi financing
Noise and StockPrices
Stabilizinggovernment
GreatModeration
The UltimateModel
Conclusions
Shortcomings of Goodwin and Keen models
No independent specification of consumption (andtherefore savings) for households:
C = W , Sh = 0 (Goodwin)
C = (1− κ(π))Y , Sh = D = Πu − I (Keen)
Full capacity utilization.
Everything that is produced is sold.
No active market for equities.
Skott (1989) uses prices as an accommodating variable inthe short run.
Chiarella, Flaschel and Franke (2005) propose a dynamicsfor inventory and expected sales.
Grasselli and Nguyen (2013) provide a synthesis, includingequities and Tobin’s portfolio choices.
Macroeconomics:
the finalfrontier
M. R. Grasselli
Mainstream
Alternativeapproaches
SFC models
Conclusions
Concluding remarks
Macroeconomics is too important to be left tomacroeconomists.
Since Keynes’s death it has developed in two radicallydifferent approaches:
1 The dominant one has the appearance of mathematicalrigour (the SMD theorems notwithstanding), but is basedon implausible assumptions, has poor fit to data in general,and is disastrously wrong during crises. Finance plays anegligible role
2 The heterodox approach is grounded in history andinstitutional understanding, takes empirical work muchmore seriously, but is generally averse to mathematics.Finance plays a major role.
It’s clear which approach should be embraced bymathematical finance “to boldly go where no man hasgone before” · · ·