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Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
Finance is not the dark side
of the force
How to build a theoretical representation of financial
instability and sustainability
Alternative ways to understand the role
of finance in Macroeconomics
© Prof. AnnaMaria Variato – Fall 2019 1
Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
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
© Prof. AnnaMaria Variato – Fall 2019 2
Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
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 AER
Reinhart and Papers and
Rogoff NBER Proceedings
n. 15639 (2010)
Reinhart and (2010)
Rogoff
Princeton
University
Reinhart and Press (2009)
Rogoff NBER
n. 13882
(2008)
© Prof. AnnaMaria Variato – Fall 2019 3
Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
Reinhart and Rogoff (2008) Reinhart and Rogoff (2009)
• This time is different: a
panoramic view of eight
centuries of financial
crises
NBER n. 13882
© Prof. AnnaMaria Variato – Fall 2019 4
Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
What does drive
the success of an economic paper?
R&R 2008: who
does know this
paper? …
But it is the most
interesting
R&R 2009 and
2010: best sellers…
but mistaken
© Prof. AnnaMaria Variato – Fall 2019 5
Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
Types of financial crises:
Reinhart and Rogoff (2008)
Currency
• Crashes
Inflation • Debasement
type I
• Debasement
type II
Banking Debt
• Systemic/Severe • Domestic
• Financial distress • Foreign
Source: Reinhart e Rogoff (2008)
© Prof. AnnaMaria Variato – Fall 2019 6
Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
Source: Reinhart e Rogoff (2008)
Mainstream puzzle 1: Does the foreign market have a long memory on default?
Foreign Public Debt: 1800-2006
% Countries Default or Restructuring
Percentuale di Paesi
Anno
Source: Reinhart e Rogoff (2008)
© Prof. AnnaMaria Variato – Fall 2019 7
Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
• Mainstream puzzle 1a: Is
default on sovreign debt a
country specific
phenomenon? Direct quote from Reinhart
and Rogoff (2008, p. 6)
• The role of systemic forces
appear to be determinant «…global economic factors,
in order to characterize including commodity prices
either the speed or the and center country interest
depth of the crisis. rates, play a major role in
• In other words, financial precipitating sovereign debt
crises seem complex crises».
phenomena, that can be
understood only taking into
account macroeconomic
interactions.
Mainstream puzzle 2: Does capital mobility foster financial markets stability?
Capital Mobility and Incidence of Bank Crisis: all countries 1800-
2007
% of contries experiencing crisis,
cumulative 3 years
Index of capital mobility
(right axis)
Capital Mobility
Share
(left axis)
Source: Reinhart e Rogoff (2008)
© Prof. AnnaMaria Variato – Fall 2019 8
Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
Mainstream puzzle 3: Does the presence of international institutions
reduce instability?
Lenght of Default episodes: 1800-2006 relative
frequency
1946-2006
169 episodes
Median 3 years
1800-1945
127 episodes
Median 6 years
Source: Reinhart e Rogoff (2008)
Mainstream puzzle 4: Does higher exchange rate flexibility reduce instability?
Currency crashes: share of contries showing
annual depreciation higher than 15%: 1800-2006
Napoleonic Wars
Source: Reinhart e Rogoff (2008)
© Prof. AnnaMaria Variato – Fall 2019 9
Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
Mainstream puzzle 5: Crisis never have a unique sympthom
Variety of crisis: 1800-2006
Average number of crisis per country 5 years average
Asia
All Countries
Source: Reinhart e Rogoff (2008)
International financial
institutions seem not
Financial Markets able to reduce
do not instability
seem to have a
long lasting
memory
Higher international
price flexibility does
not seem to produce
higher stability
More complex financial Financial Crises are not
markets do not seem to • Idiosyncratic
enhance financial stability • Exceptional
• Simple
As they are both systemic and
systematic
© Prof. AnnaMaria Variato – Fall 2019 10Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
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)
The linkage between
remuneration and
productivity has an
incentive effect
Market rewards
innovative ability
Why do markets fail?
Limited Information
Prices cannot
perform their role
(convey all relevant information)
Uncertainty
Asymmetric Information
Bounded rationality
© Prof. AnnaMaria Variato – Fall 2019 11Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
Examples of price inefficiency
Euphoria and panic
Distorted use of
information
Herd behavior
Human error: Insufficient
fraud and ignorance liquidity
Lack of
competition
Contagion
Main causes of recent financial crises
(standard view)
Microeconomic Macroeconomic
Financial fragility of
Risk appetite (too
emergent countiries
high)
(idiosynchratic)
Global real (?)
Risk evaluation convergence as
(wrong) opposed to global
financial divergence
© Prof. AnnaMaria Variato – Fall 2019 12Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
Lessons from the past
Before the crisis
Foreign capital inflows without
adequate financial reforms or gains in
productivity
(possibly excessive) credit expansion…
…mostly true for emergent economies
Structural deficiencies and/or not sound
economic policies
Lessons from the past
When the crisis sets in
Real sensitivity as a function of financial fragility
Risk evaluation as a function of complexity
Liquidity as an uncertain variable
Contagion as a qualitative phenomenon
© Prof. AnnaMaria Variato – Fall 2019 13Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
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…
© Prof. AnnaMaria Variato – Fall 2019 14Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
Elements of the «vision»:
choices one has to make
Genesis of instability
Exogenous Endogenous
Individual Behaviour
Rational Irrational
Role of Speculation
Stabilizing Destabilizing
Systemic behaviour
Random Complex
Recurrence of instability
Sporadic Cyclical
Impact of the crisis
Localized and temporary Widespread and persistent
The choices related to a Theory of
Endogenous Rational Financial Instability
Genesis of instability Endogenous
Rational
Individual Behaviour (limited rationality)
Role of Destabilizing
Speculation (mostly)
Systemic Behaviour Complex
Recurrence of
instability Cyclical
Widespread
Impact of the crisis
and persistent
© Prof. AnnaMaria Variato – Fall 2019 15Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
In order to have Rational and
Endogenous Instability
1. Simultaneous
interaction between
real and financial sides 2. Potential
of the economy conflict
(already mentioned) 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)
© Prof. AnnaMaria Variato – Fall 2019 16Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
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 financial
instability
• 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 efficient
Fact 1 – Not so negative: Financial
markets are the places where operators
mainly entertain speculative activities
Myth 1 - Negative:
financial markets are like casinos
Fact 2 – Negative: The target of financial
stability is far more difficult to reach today
than in the past
© Prof. AnnaMaria Variato – Fall 2019 17Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
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?
The characterizing
elements
of speculation Conjectures
(limited
information)
Individual
Gambling
advantage
(distribution)
(arbitrage)
In order to assess whether speculation is destabilizing or not,
one has to evaluate which of the three aspects is prevailing
© Prof. AnnaMaria Variato – Fall 2019 18Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
3a: Speculation: stabilizing or destabilizing?
• 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
Conjectures 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
Sign: ?
whether speculation is
destabilizing or not
3a: Speculation: stabilizing or destabilizing?
• The exploitation of
existing inefficiences by
some individuals make the
market converge towards
efficient equilibrium Individual
• The pursuit of individual
self-interest does not
advantage
produce negative (arbitrage)
effects at market level
• This leads to a policy
implication of laissez-
faire Sign: stabilizing
© Prof. AnnaMaria Variato – Fall 2019 19Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
3a: Speculation: stabilizing or destabilizing?
• 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
Gambling 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
Sign: destabilizing This leads to policy implication of
increasing rules in order to limit the
inefficiency due to undue redistribution
3a: Speculation: stabilizing or destabilizing?
conjectures conjectures
conjectures conjectures
© Prof. AnnaMaria Variato – Fall 2019 20Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
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
Representation
Complex Waves of
of the Regulation and What kind of
money but popularity of
trasmission of supervions not representative
simple finance authors from
monetary effective tool? ABM vs.
(which is the past: are
policy (more because of SFCA instead of
somewhat we all
complex than unique model DSGE
paradoxical) minskian?!
mainstream)
© Prof. AnnaMaria Variato – Fall 2019 21Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
The stabilization chain of events according to
mainstream view (an example inspired to R&R, 2008)
Liquidity reduces the
likelihood to face a banking
crisis
• Directly because firms have access
Higher capital to alternative financing
mobility instruments Risk reduction due to
implies • Indirectly: the existence of
Banks have more liquidity even Customization
higher when borrowers become insolvent
varieties of financial
liquidity in (lower risk of contagion) asset side instruments
the system explanation
• Indirectly: Banks have more
liquidity to face deposit runs ;
liability side explanation
• Indirectly: depositors know about
liquidity then become less prone to
withdraw
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…)
© Prof. AnnaMaria Variato – Fall 2019 22Macroeconomics Applications Università degli Studi di Bergamo a.a. 2019-2020
5. Critical Approaches to Financial
Crises: peculiar focuses
Credit lever
Individual
History behavior
(or priors) rationality, risk attitude,
imitation and power
Risk reduction +
Institutions
instruments
Liquidity
© Prof. AnnaMaria Variato – Fall 2019 23You can also read
