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
countrys 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.
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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.
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Freshwater MacroeconomicsWe 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).

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Freshwater MacroeconomicsWe 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.
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Neo-Keynesian Theory Fragility is Due to
Irrationality
Prominent Keynesian economists George Akerlof and
Bradley Schillers Animal Spirits (Princeton,
2009) has become the rallying-cry for the
reassertion of the importance of government
regulation of the financial sector.
George Akerlof
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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
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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.
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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
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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.
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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.
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What is General Equilibrium?
The Walrasian economy is in equilibrium when
prices are set so that supply demand for each
good in the economy.
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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-
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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.
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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.
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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.

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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.
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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.
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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.
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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.
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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.
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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.
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Private to Quasi-Public Prices
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Quasi-Market Clearing
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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.
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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.
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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.
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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 gt 0 leads to a
single firm entering the sector, and average
profits lt 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
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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.
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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 from labor
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.
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Price Stability with Excursions
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Price Stability with Excursions
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Excess Demand and Supply
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Profits
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Unemployment
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Unemployment
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Stability
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Stability
percent

• The vertical axis shows percentage efficiency.

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Stability
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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.