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Answer to the Queen

December 12, 2010

Listen to this episode


Econ Intersect, John Lounsbury

“No One Saw This Coming,” Dirk Bezemer, Gronigen Univesity

“Why Credit Money Fails,” Steve Keen (with access to video and audio)

Professor Luis Garicano, director of research at the LSE’s management department, said: ‘The Queen asked me, “If these things were so large, how come everyone missed them?”.’

Today the answer to the Queen

The macro model that is used by policy planners in the Fed and in government goes by the name of the Washington University Macro Model. In a research paper entitled “No One Saw this Crisis Coming”, published in June 2009 by Dirk J. Bezemer, Groningen University, Mr. Bezemer describes that model thusly:

The “WUMM” is a quarterly econometric system of roughly 600 variables, 410 equations, and 165 exogenous variables. … the important observation is that all are real-sector variables except the money supply and interest rates, the values of which are in turn fully determined by real-sector variables. In contrast to accounting models, the financial sector is thus absent (not explicitly modelled) in the model.

In other words, the elements in the economy that are at the root cause of the current crisis are absent from the models of economic activity that are used to guide economic policy. The entire financial sector is absent. The very elements that have siphoned the life blood out of the economy have been completely off the radar screen. The FIRE was hidden behind a shield of invisibility, just pumping money into their coffers until the real economy bled out.

Here from the outstanding piece on the excellent blog Global Economic Intersection, we continue with John Lounsbury’s account of the Bezemer paper

… macro equilibrium theory dominates academia and has become institutionalized in governments. Bezemer defines the objective of his paper to encourage the merging of accounting and economic theory. He [notes that most of the analysts who got it right] reject rational equilibrium on the basis of arguments related to economic psychology and to the Keynesian notion of ‘radical uncertainty’ (as opposed to calculable risks). Keen, in a 1995 article titled ‘Finance and Economic Breakdown’ explained that “Keynes argued that uncertainty cannot be reduced to ‘the same calculable states as that of certainty itself’ whereas the kind of uncertainty that matters in investment is that about which “there is no scientific basis on which to form any calculable probability whatever. We simply do not know” Keynes argued that in the midst of this incalculable uncertainty, investors form fragile expectations about the future, which are crystallized in the prices they place upon capital sets, and that these prices are therefore subject to sudden and violent change.

Bezemer points out that the critical elements of human behavior and confidence are not reflected in the snapshots of the macro equilibrium models, but are amenable to modeling in a flow-of-cash model [, but] He is not proposing that the macro models be discarded; he feels they should be supplemented and expanded to include flow-of-cash factors.

Bezemer says that those who foresaw the coming crisis share the general characteristic that they viewed the economy through an accounting models lens. He wrote,

They are ‘accounting’ models in the sense that they represent households’, firms’ and governments’ balance sheets and their interrelations. [A] society’s wealth and debt levels reflected in balance sheets are among the determinants of its growth sustainability and its financial stability, [so] such models are likely to [provide] timely signals [of] threats [to financial stability].

Models that do not – such as the general equilibrium models widely used in academic and CentralBank analysis – are prone to ‘Type II errors’ of false negatives – rejecting the possibility of crisis when in reality it is just months ahead. Moreover, if balance sheets matter to the economy’s macroperformance, then the development of micro-level accounting rules and practices are integral to understanding broader economic development.

The finance, insurance and real estate (FIRE) sector includes all sorts of wealth-managing non-bank firms (pension funds, insurers, money managers, merchant banks, real estate agents etc.), as well as deposit-taking banks, which generate credit flows. It is conceptually separate from the real sector which comprises government, firms and households.

Liquidity from the FIRE sector flows to firms, households and the government as they borrow. It facilitates fixed-capital investment, production and consumption, the value of which – by accounting necessity – is jointly equal to real-sector income in the form of profit, wages and taxes plus financial investment and obligations (principally, interest payments).

Problems arise when the funds that originate in the banking part of the FIRE sector return to the FIRE sector in the form of investments or payment of debt service to the exclusion of circulation in the real economy. These problems can lead to recessionary economic collapse (although soft landings are possible), and, in the most severe dislocations, depressions.

Bezemer describes the details of how the accounting model displays the unfolding of the economic cycle:

An accounting (or balance sheet) view of the economy makes clear that this dynamic – a bubble – is unsustainable in the sense that it is constrained by the real economy’s ability to service debt. Yet without policy intervention, it can last for many years or even decades if starting from low levels of indebtedness. A bust occurs as investors realize this constraint is approaching or has been reached. The severity of the impact of a bust will be the larger as real-economy consumption (and thereby production) have grown more dependent on capital gains rather than on wages and profit.

This ‘financialisation’ scenario is a self-sustained dynamic separate from real-sector fundamentals (in other words, a bubble) increasing debt burdens but not bolstering the real economy’s potential to create value added from which to repay its growing debt. It is typically driven by the psychological and political economy factors …. In terms of financial incentives, its impetus is that it brings increased asset price gains for a time, but this is unsustainable in the long term as a source of debt servicing. Borio (2004:5) writes that “contrary to conventional wisdom, the growth of markets for tradable instruments …[read securitization] need not have reduced the likelihood of funding (liquidity) crises”. On the contrary, applying an accounting lens demonstrates that because of the debt growing in parallel with tradable instruments, inevitably a bad loan problem (or debt crisis) develops, credit flows dry up …

That summary had a lot of help from World Economic Intersection, probably the best blog now up for forecasters. Link online.

As we continue to follow the pipers of Wall Street and the IMF, it is probably time to list those who actually saw the crisis coming.

Dean Baker
Wynne Godley
Fred Harrison
Michael Hudson
Eric Janszen
Stephen Keen
Jakob Brochner Madsen and Jens Kjaer Sorensen
Kurt Richebacher
Nouriel Roubini
Peter Schiff
Robert Shiller

Now we turn to audio — pungent audio — from Stephen Keen, whose explanation is even more clear.


This talk from Keen is available with all its graphics online. Find our link at the blog. We excise the presentation of his dynamic model at this point and pick up at the end of his talk, with a summary of his conclusions.


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