One of the major issues with the internal logic of neoclassical macro is the handling of credit risk. The problem of credit is acute for Dynamic Stochastic General Equilibrium models because they are allegedly based on “microfoundations.” However, the theoretical problems remain for any aggregated mathematical model. The advantage of heterodox economists is that they do not make a big deal about the alleged internal consistency of their mathematical models, and so they are more willing to hand wave around the issue.Bond Economics
(To be fair, if we go back to earlier “mainstream” economists, the issues I raised here were probably discussed in the textual analysis. However, mainstream economics is an academic field where knowledge is effectively subtractive, and so any earlier insights into credit were lost by 2007, only to be re-discovered the hard way.)
The issue is the notion of aggregation — we could possibly get a handle on credit in an agent-based model. I have discussed this topic before — for example, Hyman Minsky’s “Financial Instability Hypothesis” refers to “units,” which would be translated into “agents” in modern “agent-based modelling” terminology. Although I am pretty sure that I have discussed this before, I want to take a stab at the issues with credit modelling alone.…
The Perplexing Problem Of Credit In Macro
Brian Romanchuk
http://www.bondeconomics.com/2022/07/the-perplexing-problem-of-credit-in.html
3 comments:
If we look at default events, they are not exactly “random”: the state of the borrower’s finances are determined by the state of the economy.
The same point is made in the following insightful article about the events that led to the housing bubble and the 2008 subsequent crash. Well worth reading [bold mine].
Recipe for Disaster: The Formula That Killed Wall Street
To understand the mathematics of correlation better, consider something simple, like a kid in an elementary school: Let's call her Alice. The probability that her parents will get divorced this year is about 5 percent, the risk of her getting head lice is about 5 percent, the chance of her seeing a teacher slip on a banana peel is about 5 percent, and the likelihood of her winning the class spelling bee is about 5 percent. If investors were trading securities based on the chances of those things happening only to Alice, they would all trade at more or less the same price.
But something important happens when we start looking at two kids rather than one—not just Alice but also the girl she sits next to, Britney. If Britney's parents get divorced, what are the chances that Alice's parents will get divorced, too? Still about 5 percent: The correlation there is close to zero. But if Britney gets head lice, the chance that Alice will get head lice is much higher, about 50 percent—which means the correlation is probably up in the 0.5 range. If Britney sees a teacher slip on a banana peel, what is the chance that Alice will see it, too? Very high indeed, since they sit next to each other: It could be as much as 95 percent, which means the correlation is close to 1. And if Britney wins the class spelling bee, the chance of Alice winning it is zero, which means the correlation is negative: -1.
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In the world of mortgages, it's harder still. What is the chance that any given home will decline in value? You can look at the past history of housing prices to give you an idea, but surely the nation's macroeconomic situation also plays an important role. And what is the chance that if a home in one state falls in value, a similar home in another state will fall in value as well?
David X. Li's Gaussian copula function as first published in 2000. Investors exploited it as a quick—and fatally flawed—way to assess risk. A shorter version appears on this month's cover of* Wired.
The question here is why do we care about credit in macro?
Credit is something the private sector produces. Like accounting entries, or bottles of pickles. Since we don't care about the quantity and price of the latter in detail, why do we care about the former so much? Why can't the 'free market' decide how much to produce, and let the forces of competition and bankruptcy determine how that comes about.
The problem we have is that banks can't go bust easily enough - because they have depositors and run the payment system. Decouple that - so that individuals can take their account to any payment provider on a payment by payment basis, and have their deposits decoupled from banks completely - and there doesn't seem to me much reason why we can't just let banks compete and go bust if they overland, or lend badly.
Then we just manage that version of the horizontal circuit via automatic stabiliser systems in the vertical circuit.
Of course it is possible to design systems for effectiveness, with efficiency and resilience, but that is not what modern "capitalism" is about.
According to the naturalists, just ensuring a "free market" would take care of this with the "invisible hand," but as Joseph Stiglitz once famously said, "There is no invisible hand."
Rather, it all depends on the institutional arrangements and who sets them. That is decided by political power, which under "capitalism" is decided by wealth. That is the definition of plutocratic oligarchy.
Yes, it is possible to change this under representative democracy, and that is why narrative control is crucial to the holders of power and they use every means available, fair or foul, to do so.
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