Finance isnotthe dark side of the force

Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020

© Prof. AnnaMaria Variato – Fall 2019 1

Finance is not the dark side

of the forceHow to build a theoretical representation of financial

instability and sustainability

Alternative ways to understand the role

of finance in Macroeconomics



FACING THE FINANCIAL CRISES OF THE

RECENT PAST

Overview of the Presentation

1. Empirical evidence: contrasting facts and theoretical

implications

2. Attempts to rationalize puzzling evidences related to

financial crises

3. Dangers of reductionist views of finance: two extremes

and a middle ground nearby speculation

4. Critical perspectives on financial crises after the 1990:

historical overview

5. Critical perspectives on mainstream approach to

financial crises: peculiar focuses



1. Empirical evidence

• In the last decades events at international level have

shown that finance have strong destabilizing effects

• Crisis of financial nature become more frequent,

deeper, contagiuos and affect all kind of systems

(even highly developed economies)

Two kinds of problems:

• Interpretation (collect the relevant issues)

• Representation (build a theoretical synthesis)

«The Curious Case of Reinhart and Rogoff»

Reinhart and Rogoff NBER n. 13882 (2008)

Reinhart and RogoffPrinceton UniversityPress (2009)

Reinhart and Rogoff NBER n. 15639 (2010)

Reinhart and Rogoff AER Papers and Proceedings(2010)



Reinhart and Rogoff (2008) Reinhart and Rogoff (2009)

• This time is different: a

panoramic view of eight

centuries of financial

crises

NBER n. 13882



What does drive

the success of an economic paper?

R&R 2008: whodoes know this

paper? …

But it is the mostinteresting

R&R 2009 and 2010: best sellers…

but mistaken



Types of financial crises:

Reinhart and Rogoff (2008)

Inflation

Currency

• Crashes

• Debasementtype I

• Debasementtype II

Banking

• Systemic/Severe

• Financial distress

Debt

• Domestic

• Foreign

Source: Reinhart e Rogoff (2008)




Anno

Pe

rce

ntu

ale

di

Pa

es

i

Foreign Public Debt: 1800-2006

% Countries Default or Restructuring


Mainstream puzzle 1: Does the foreign market have a long memory on default?



• Mainstream puzzle 1a: Isdefault on sovreign debt a country specificphenomenon?

• The role of systemic forces appear to be determinant in order to characterize either the speed or the depth of the crisis.

• In other words, financial crises seem complex phenomena, that can be understood only taking into account macroeconomic interactions.

Direct quote from Reinhartand Rogoff (2008, p. 6)

«…global economic factors, including commodity prices and center country interest rates, play a major role in precipitating sovereign debt crises».


Ind

ex

of

ca

pit

al

mo

bil

ity

Sh

are

Capital Mobility and Incidence of Bank Crisis: all countries 1800-

2007

Capital Mobility

(left axis)

% of contries experiencing crisis,

cumulative 3 years

(right axis)

Mainstream puzzle 2: Does capital mobility foster financial markets stability?




Lenght of Default episodes: 1800-2006 relative

frequency

1946-2006

169 episodes

Median 3 years

1800-1945

127 episodes

Median 6 years

Mainstream puzzle 3: Does the presence of international institutions

reduce instability?


Currency crashes: share of contries showing

annual depreciation higher than 15%: 1800-2006

Napoleonic Wars

Mainstream puzzle 4: Does higher exchange rate flexibility reduce instability?




Variety of crisis: 1800-2006

Average number of crisis per country 5 years average

All Countries

Asia

Mainstream puzzle 5: Crisis never have a unique sympthom

More complex financial

markets do not seem to

enhance financial stability

Financial Markets

do not

seem to have a

long lasting

memory

International financial

institutions seem not

able to reduce

instability

Higher international

price flexibility does

not seem to produce

higher stability

Financial Crises are not

• Idiosyncratic

• Exceptional

• Simple

As they are both systemic and

systematic



Further puzzles: Micro-macro conflict(fallacy of composition in financial markets)

Savers are rational

(as any other

economic agent)Financial markets are

competitive

(as any other market)

Market rewards

innovative ability

The linkage between

remuneration and

productivity has an

incentive effect

Why do markets fail?

Limited Information

Uncertainty

Asymmetric Information

Bounded rationality

Prices cannot

perform their role(convey all relevant information)



Examples of price inefficiency

Distorted use of

information

Herd behavior

Lack of

competition

Insufficient

liquidity

Contagion

Euphoria and panic

Human error:

fraud and ignorance

Main causes of recent financial crises(standard view)

Microeconomic

Risk appetite (toohigh)

Risk evaluation(wrong)

Macroeconomic

Financial fragility of emergent countiries

(idiosynchratic)

Global real (?) convergence as

opposed to global financial divergence



Lessons from the past

Before the crisis

(possibly excessive) credit expansion…

…mostly true for emergent economies

Foreign capital inflows withoutadequate financial reforms or gains in productivity

Structural deficiencies and/or not sound economic policies

Lessons from the past

When the crisis sets in

Risk evaluation as a function of complexity

Real sensitivity as a function of financial fragility

Liquidity as an uncertain variable

Contagion as a qualitative phenomenon



Even though stability is not an

autonomous feature of financial

markets, why do we need stable and

efficient financial markets?

• Dimension

• Connection contagion

• Instability determined

– Directly: type of good exchanged

– Indirectly: income effect

Whenever a crisis hits a system, the Economsit is

supposed to provide a satisfactory vision explaining

the originating prcess, the transmission mechanism

and the possible solution …

Of course it would be much better to be able to

predict and then prevent…



Elements of the «vision»:

choices one has to make

Impact of the crisis

Localized and temporary Widespread and persistent

Recurrence of instability

Sporadic Cyclical

Systemic behaviour

Random Complex

Role of Speculation

Stabilizing Destabilizing

Individual Behaviour

Rational Irrational

Genesis of instability

Exogenous Endogenous

The choices related to a Theory of

Endogenous Rational Financial Instability

Genesis of instability

Individual Behaviour

Role of

Speculation

Systemic Behaviour

Recurrence of

instability

Impact of the crisis

Rational

(limited rationality)

Endogenous

Destabilizing

(mostly)

Complex

Cyclical

Widespread

and persistent



In order to have Rational and Endogenous Instability

1. Simultaneous

interaction between

real and financial sides

of the economy(already mentioned)

2. Potential

conflict

between micro

and macro

instances(already mentioned)

3. Instability as an effect of the interaction between the

structure of the economy (fundamentals) and

automatic market adjustments

Role of

fundamentals

• Economic Policy mistakes• (1929, Asia 1997, Brazil 1998, EU austerity)

• Correct Policy but mistaken

anticipation• (Usa 1994 and following Messico 1995)

• role of communication and risk of moral

hazard (USA 1987, Giappone 1989)



2. Attempts to rationalize puzzling

evidence (just a synthesis)

• Many attempts, different languages, different emphasis…

• Usually no need to come up with a unifying theory of financialinstability

• Common criticism against mainstream: fallacious implications due to excess of reduction.

• Mainstream approach fails because of its inductive approach. This kind of reductionism transforms what is supposed to be a representative expedient (or a tool for representation) into an homologation instrument (a model which drives out of the system the varieties not implied by the representation).

• Whenever finance is depicted through an extreme reductionist approach, the likely effect is to have it represented by myths instead of facts. This becomes especially dangerous when the models are used as frameworks for economic policy design.

3. Dangers related to reductionsit views

Myth 2 - Positive: financial markets are efficientFact 1 – Not so negative: Financial markets are the places where operatorsmainly entertain speculative activities

Myth 1 - Negative:

financial markets are like casinosFact 2 – Negative: The target of financialstability is far more difficult to reach todaythan in the past



Stop and ask:

Implicitly the myths deal (at least) with

four fundamental concepts, treating

them in a particular (simplified and

opposite) perspective.

Can you tell which they are?

3a: Speculation: stabilizing or destabilizing?

Conjectures(limited

information)

Gambling(distribution)

Individualadvantage(arbitrage)

The characterizing

elements

of speculation

In order to assess whether speculation is destabilizing or not,

one has to evaluate which of the three aspects is prevailing




Conjectures

• The fact information is

limited is the intrinsic

structural feature of any

speculative framework

• It implies the need to form

expectations and/or to extract

signals in order to come up to

a decision.

• the type and qualitative

features of information limit

will eventually determine The

kind of inefficiency.

i.e. one cannot say in principle

whether speculation is

destabilizing or not

Sign: ?


Individualadvantage(arbitrage)

• The exploitation of

existing inefficiences by

some individuals make the

market converge towards

efficient equilibrium

• The pursuit of individual

self-interest does not

produce negative

effects at market level

• This leads to a policy

implication of laissez-

faire Sign: stabilizing




Gambling

• Even though it requires

conjectures, it does not need them

essentially:

• the scope of this activity

is to alter resource distribution (like

arbitrage): differently from arbitrage,

gambling activity involves agents who are

aware of the bet

• If one wants to bet and then looses, this

is not the business of the economist

• The economist is interested when the

gamble implies cheating from one side,

and the other is not aware of the

existence of the gamble (or of its true

nature)

i.e. what matters is unfair gambling

This leads to policy implication of

increasing rules in order to limit the

inefficiency due to undue redistribution

Sign: destabilizing


conjectures conjectures

conjectures conjectures



4. Historical overview of recent

financial crises

If so many and articulated explanations, why no sign to prevent

2007 crisis? It was not a surprise, but…

4.1 Main critical accounts prior 2007 crisis

Representationof the

trasmission of monetary

policy (more complex thanmainstream)

Regulation and supervions not

effectivebecause of

unique model

Complexmoney but

simple finance(which is

somewhatparadoxical)

What kind of representativetool? ABM vs.

SFCA instead of DSGE

Waves of popularity of authors from the past: are

we allminskian?!



The stabilization chain of events according to

mainstream view (an example inspired to R&R, 2008)

Higher capital mobilityimplieshigher

liquidity in the system

Liquidity reduces the likelihood to face a banking crisis

• Directly because firms have accessto alternative financinginstruments

• Indirectly:

Banks have more liquidity evenwhen borrowers become insolvent(lower risk of contagion) asset side explanation

• Indirectly: Banks have more liquidity to face deposit runs ; liability side explanation

• Indirectly: depositors know aboutliquidity then become less prone to withdraw

Risk reduction due to the existence of

varieties of financialinstruments

Customization

Policy implications arising from the

stabilization chain of events according to

mainstream view

• Banking oriented systems are less efficient than market

oriented systems

• The presence of a banking oriented system is symptom of

backwardness

• Banking oriented systems are more unstable than market

oriented systems

Hence promote market oriented systems (and let banks

disappear… One may quote Bill Gates…)



5. Critical Approaches to Financial

Crises: peculiar focuses

Credit lever

Individualbehavior

rationality, risk attitude, imitation and power

Risk reduction + instruments

Liquidity

Institutions

History(or priors)

Finance isnotthe dark side of the force

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