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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
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
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.
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 country’s inability to sustain debt service is a
“public secret”
for reasons that are incompletely understood.
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.
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.
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.
Freshwater Macroeconomics:
We 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
Robert Lucas
financial assets…
[This] has been known for more than 40 years and is
one of the main implications of the efficient-market
hypothesis (EMH).
Freshwater Macroeconomics:
We 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.
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.
Neo-Keynesian Theory:
Fragility is Due to Irrationality
Prominent Keynesian economists George
Akerlof and Bradley Schiller’s
Animal Spirits (Princeton, 2009)
has become the rallying-cry for the
reassertion of the importance of
government regulation of the
financial sector.
George Akerlof
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
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.
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
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.
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.
What is General Equilibrium?
The Walrasian economy is
in equilibrium when prices
are set so that supply =
demand for each good in
the economy.
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-
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.
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.
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,
5. Then back to 1, until all markets are in equilibrium.
6. Only then is production and trade permitted, at the
specified market-clearing prices.
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.
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.
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.
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.
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.
A Decentralized Market System
with Individual Production
I have explored decentralized market economies in several
publications (e.g., Gintis 2007, 2012a,b), using agentbased 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-marketclearing prices in almost all periods.
Private to Quasi-Public Prices
Quasi-Market Clearing
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.
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.
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.
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 > 0 leads to a single firm entering
the sector, and average profits < 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
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.
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.
Price Stability with Excursions
Price Stability with Excursions
Excess Demand and Supply
Profits
Unemployment
Unemployment
Stability
percent
Stability
•The vertical axis shows percentage efficiency.
Stability
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.