Frances Coppola — Productivity, savings and financial crises

Frances Coppola analyzes ECB Working Paper, "Booms and Systemic
Banking Crises" by Frederic Boissay, Fabrice Collard and Frank Smets (February 2013)

The ECB's paper makes a valiant attempt to fit the financial system into a DSGE model of the economy that previously ignored it. The maths is fearsome and I admit I skipped much of it. But they draw some important conclusions.

Very early in the paper they accept the prevailing wisdom that financial crises are endogenously determined - in other words, they happen as a consequence of behaviour within the system, not because of external shocks to it. Now this immediately causes a problem with the model. DSGE models work on the basis that shocks are exogenous - sort of like meteorite impacts on life on earth. But using the same analogy, an endogenous crisis would be CAUSED by the behaviour of life on earth. Attempting to use a DSGE model to explain the effects of the behaviour of humans on their own behaviour is enough to drive a serious economist to drink. Admittedly there are shocks in the model, but adverse ones are regarded as secondary and the causative positive supply-side shocks they postulate happen some time before the crisis itself. They cause the buildup of the behaviour that leads to the crisis, rather than the crisis itself. This I think is an important insight, and I commend the ECB economists for sticking to their guns despite the considerable difficulty in using a model that on the face of it looks inappropriate.

Coppola Comment
Productivity, savings and financial crises
Frances Coppola