1.4: Risk Reduction
Reduce uncertainty on the possible impacts of policies Other Information:
When policy options have been developed, simulations are carried out to anticipate the likely impact of policies. The option
with the most positive impact is normally the one that is proposed for adoption. Existing methodologies and tools for the
simulation of policy impacts work decently well with well known, linear phenomena on which a massive quantity of historical
data are available. However, they are not effective in times of crisis and fast change, which unfortunately turn out to be
exactly the situations where government intervention is most needed. On the top of that, often the analytical frameworks and
tools adopted in governments and international institutions are well below the academic standards. Furthermore many international
institutions, such as the IMF, tend to recruit personnel from a very exclusive group of economic departments in which the
very concept of general equilibrium was developed. As an example nowadays the European Central Bank bases its analysis of
the EURO Area economy and monetary policy on a derived version of the DSGE model developed by Frank Smet and Raf Wouters in
20032. Smet and Wouters' model is deeply microfounded, allowing for a rigorous theoretical structure of the model. Moreover
in this setting the reduced form parameters are related to deep structural parameter in order to mitigate Lucas' critique,
while the utility of agents can be taken as a measure of welfare in the economics. However, the DSGE models suffer from several
shortcuts jeopardizing their ability to predict, let alone to prevent, global crisis: • Agents are assumed to be perfectly
rational, having perfect access to information and adapting instantly to new situations in order to maximize their long- run
personal advantage • So far agents have entered the models as homogeneous representative entities, while it would be a step
forward being able to take into account agents heterogeneity • Canonical models consider atomistic agents with little or no
interactions and thereby are not able to cope with network externalities But most of all it is the very notion of stable steady
state equilibrium which prevents standard models from dealing with crisis. A stable steady state equilibrium is a condition
according to which the behaviour of a dynamical system does not change over time or in which a change in one direction is
a mere temporary deviation. This condition is proper of general equilibrium theory, in which a stable steady state is believed
to be the norm rather than the exception. When in the canonical model we are out of equilibrium, the situation is seen just
as a short lapse before the return to the steady state. This is in sharp contrast with the very notion of crisis, which represents
a steady deviation from the equilibrium. Loosely speaking, the crisis phenomenon is not even conceived within the framework
of standard models. All these flaws are not only related to DSGE models, Computational General Equilibrium (CGE) or macro-
econometric forecasting models, but generally affect the traditional policy making tools. In this view it would be very important
to find new frameworks capable of avoiding those shortcuts. We need to move away from the equilibrium paradigm in order to
be able to assess other issues: evolutionary dynamics; heterogeneity of technologies and firm; political and legal determinants
of social stability; incentive structures; better modelling technological change, innovation diffusion and economic systems
(taking into account finance, debt and insurance); interactions between heterogeneous economic agents (firms and households)
and central governments; heterogeneous responses to government incentives; economic dependence from the ecosystem. Furthermore
in the future it will become more and more important to anticipate non- linear potentially catastrophic impacts from climate
change (draught and global warming); threshold climate effects such as poles' sea- ice withdraw, out- gassing from melting
permafrost, Indian monsoon, oceans acidification, and finally effects on economic well being due to social instability (social
conflict, anarchy and mass people movements). Trichet, the former head of ECB, clearly put it: "This doesn't mean we have
to abandon DSGE...(but)...atomistic rational agents don't capture behaviour during a crisis...rational expectations theory
has brought macroeconomics a long way ... but there is a clear case to re- examine the assumptions" Lack of understanding
of systemic impact has driven to short term policies which failed in grasping long term or systemic consequences: - - The
clearest example of this approach works through the sovereign debt. In some periods some European countries (e.g. Italy) increased
expenditure and public debt to cope with short term necessities, without taking into account the long term effect determined
by higher interest rates on private investments and consumption through crowding out and fiscal pressure - Another clear example
of short- termism are the financial policies pursued in south East Asia at the beginning of the 90s. Many countries, such
as Thailand, liberalized their financial markets fostering the inflow of investments aimed at sustaining growth. Unfortunately
those capitals triggered a real estate bubble which has been at the roots of the 1997- 1998 crisis - In 2008 the Central Bank
of Iceland yielded liquidity loans for saving banks on the verge of default on the basis of newly- issued, uncovered bonds,
i.e. effectively printing fiat money on demand, causing a significant rise in inflation. To cope with this rise in prices,
the Iceland Central Bank had to keep very high interest rates thereby leading to an economic bubble - According to a great
number of economists the financial crisis was triggered by US government policies spanning across two administration which
were intended to ensure citizens' right but instead determined an unprecedented high number of risky mortgages, as well as
the decline in mortgage underwriting standards that ensued. According to the "Financial Crisis Inquiry Commission Report3"
those policies, together with the deregulation of the financial system, might have been catalyzed the crisis. - Other examples
can be the bail out of financial institutions: in the short run those actions maintain employment and economic standards,
while in the long they induce moral hazard, keep operating inefficient companies and decrease the trust of economic agents
in regulation, which is the funding pillar of our economic system
Indicator(s):
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