Friday, May 20, 2011

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.

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