This time is different, again?

By Don Alexander
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

The strength of the US recovery has become a political issue in the presidential election. The US is doing better than other advanced economies, but some economists associated with the Romney campaign say this is not good enough. The US, they argue, is different.

Carmen Reinhart and Ken Rogoff, in a recent VOXEU communiqué - This time is different, again? The US five years after the onset of subprime (Oct. 22^nd) – argue that US historical performance is not different when it is properly measured, so the economy’s performance is better than expected.  The authors note that GDP per capita in the US remains below its initial level while unemployment rate is still hovering near 8%. This is typical of downturns that are associated with systemic banking crisis that tend to be deep and protracted.

A number of op-ed writers and economists stress that the US is also 'different' noting that recoveries from earlier recessions associated with financial crises have been rapid and strong. The authors suggest part of the confusion is a failure to distinguish systemic financial crises from more minor ones and from regular business cycles.  A systemic financial crisis affects a large share of a country’s financial system and are distinct from less severe events that do not cause a systemic meltdown ('borderline' crises). The distinction between a systemic and a borderline event is well established according to widely accepted criteria.

How a recovery is measured is also important as is the way success is defined. The recent pundit focus on GDP growth immediately following the trough (usually four quarters).  This is characterized as a V-shaped recovery, the old peak level of GDP is quickly reached, and the economy returns to trend within a year or two.

According to metrics established by the authors in earlier studies, the aftermath of the current US financial crisis has been quite typical of post-war systemic financial crises around the globe. If one really wants to focus just on US systemic financial crises, then the recent recovery looks positively brisk.  In addition, they look at systemic crises in other advanced countries and find that the recovery has the same metrics.

While no two crises are identical, there are some robust recurring features of crises that cut across time as well as across national borders. Common patterns as regards the nature of the long boom-bust cycles in debt and their relationship to economic activity emerge as a common thread across very diverse institutional settings.

The most recent US crisis appears to fit the more general pattern that the recovery process from severe financial crisis is more protracted than from a normal recession or from milder forms of financial distress. There is certainly little evidence to suggest that this time was worse.  This does not mean policy is irrelevant. There was almost certainly a palpable risk of another depression.  The challenges in recovering from a financial crises are daunting, an early recognition of the likely depth and duration of the problem would be helpful in assessing various options and their attendant risks.  The latest US financial crisis and fragile recovery, yet again, proved it is not different.

www.voxeu.org/article/time-different-again-us-five-year

This time is different, again?

By Don Alexander
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

The strength of the US recovery has become a political issue in the presidential election. The US is doing better than other advanced economies, but some economists associated with the Romney campaign say this is not good enough. The US, they argue, is different.

Carmen Reinhart and Ken Rogoff, in a recent VOXEU communiqué - This time is different, again? The US five years after the onset of subprime (Oct. 22^nd) – argue that US historical performance is not different when it is properly measured, so the economy’s performance is better than expected.  The authors note that GDP per capita in the US remains below its initial level while unemployment rate is still hovering near 8%. This is typical of downturns that are associated with systemic banking crisis that tend to be deep and protracted.

A number of op-ed writers and economists stress that the US is also 'different' noting that recoveries from earlier recessions associated with financial crises have been rapid and strong. The authors suggest part of the confusion is a failure to distinguish systemic financial crises from more minor ones and from regular business cycles.  A systemic financial crisis affects a large share of a country’s financial system and are distinct from less severe events that do not cause a systemic meltdown ('borderline' crises). The distinction between a systemic and a borderline event is well established according to widely accepted criteria.

How a recovery is measured is also important as is the way success is defined. The recent pundit focus on GDP growth immediately following the trough (usually four quarters).  This is characterized as a V-shaped recovery, the old peak level of GDP is quickly reached, and the economy returns to trend within a year or two.

According to metrics established by the authors in earlier studies, the aftermath of the current US financial crisis has been quite typical of post-war systemic financial crises around the globe. If one really wants to focus just on US systemic financial crises, then the recent recovery looks positively brisk.  In addition, they look at systemic crises in other advanced countries and find that the recovery has the same metrics.

While no two crises are identical, there are some robust recurring features of crises that cut across time as well as across national borders. Common patterns as regards the nature of the long boom-bust cycles in debt and their relationship to economic activity emerge as a common thread across very diverse institutional settings.

The most recent US crisis appears to fit the more general pattern that the recovery process from severe financial crisis is more protracted than from a normal recession or from milder forms of financial distress. There is certainly little evidence to suggest that this time was worse.  This does not mean policy is irrelevant. There was almost certainly a palpable risk of another depression.  The challenges in recovering from a financial crises are daunting, an early recognition of the likely depth and duration of the problem would be helpful in assessing various options and their attendant risks.  The latest US financial crisis and fragile recovery, yet again, proved it is not different.

www.voxeu.org/article/time-different-again-us-five-year

Complexity, Economics & Systemic Risk

by Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

There is a long list of culprits when it comes to assigning blame for the financial crisis. A number of recent papers such as, Andrew Haldane “What have economists ever done for us” (VOXEU, Oct. 1st) argues economists are among the guilty, falling to an intellectual virus of theory-induced blindness. Haldane calls for an intellectual reinvestment in models of heterogeneous, interacting agents, which may require an examination of other disciplines.

Concurrently, Robert May wrote a recent column in the Financial Times “In finance too, complex ecosystems can be vulnerable” (FT, Oct. 21^st).  He notes there are some parallels between complexity in financial systems and eco-systems in zoology.  The greater the complexity in an eco-system (more species and greater interactions among them) the more vulnerable it may become to environmental shocks (May-Wigner theorem).  A general statement can be said, it is that stressful environments tend to be associated with simple not complex ecosystems.  The introduction of an alien species into a complex ecosystem can result in a complete disruption.  Financial systems continue to increase in complexity through greater interconnections and expansion with computer power.

There are several lessons that can be drawn from ecology and complex systems:  (1.) the regulatory focus is primarily on individual entities, but now the focus from recent events is shifting to systems.  In particular, the failure on one bank, through interconnections, can propagate throughout the whole system (super spreaders of infections).  Large, complex banks need to hold large capital reserves.  (2.) The prevention of contagion is laudable, but it is better to avoid failure in the first place.  For example, do we fully understand the pricing of derivatives that are largely based on simplistic, perfect market conditions?  This may actually increase system vulnerability through faulty assumptions.  (3.)  There are concerns that that we do not fully understand the dynamics of banking systems.  Banks are a larger part of the economy, but the foundation for regulations is coming from Basel I & II.  The risk is that by only addressing some fundamental issues, the new regulations are making the system more complex.

The main lesson is that in a complex, species-rich ecosystems can persist in relatively predictable environment.  However, the introduction of an alien species can produce pressures that may cause wide environmental fluctuations (financial systems & complexity).

Haldane notes that economists have tended to ignore cycles in money and bank credit. The interplay of bank money and credit and the wider economy has been pivotal to the mandate of central banks for centuries.  Two developments – one academic, one policy-related – appear to have been responsible. The first was the emergence of micro-founded dynamic stochastic general equilibrium (DGSE) models in economics which downplayed the role of financial factors.  The second was an accompanying neglect for aggregate money and credit conditions in the construction of public policy frameworks and neglect of bank balance sheets.

The lessons of financial history have been painfully re-taught and it underscores the importance of sub-disciplines such as economic and financial history. Second, it underlines the importance of reinstating money, credit and banking, as well as refocusing on models of the interplay between economic and financial systems.  Third, the crisis showed that institutions really matter, be it commercial banks or central banks, when making sense of crises, their genesis and aftermath.

There is increased integration of markets of all types, economic, but especially financial and social.  The dynamics in socioeconomic systems are becoming increasingly familiar, but with a fragile property: swan-like serenity one minute, riot-like calamity the next. These dynamics do not emerge from most mainstream models of the financial system or real economy. The majority of these models use the framework of a single representative agent (or a small number of them). That effectively neuters the possibility of complex actions and interactions between agents shaping system dynamics.

The financial system is an archetypical complex, adaptive socioeconomic system – and has become more so over time. In the early years of this century, financial chains lengthened dramatically, system-wide maturity mismatches widened alarmingly and intrafinancial system claims ballooned exponentially. The system became, in consequence, a hostage to its weakest link. When that broke, so too did the system as a whole. Communications networks and social media then propagated fear globally.

Conventional models, based on the representative agent and with expectations mimicking fundamentals, cannot capture the system dynamics. They are fundamentally ill-suited to capturing today’s networked world, in which social media shape expectations, shape behavior and thus shape outcomes.  Can economists learn to understand the dynamics of systemic risk?

www.ft.com/intl/cms/s/a6ee48b4-0d63-11e2-99a1-00144.

www.voxeu.org/article/what-have-economists-ever-done-us