Saturday, February 25, 2012

Amplification and Indeterminacy

How do we want to think about financial crises? We have some idea that there is something unusual going on - something we might see every 15, 20, or 30 years, say, in a given economy. But what is the process that drives a financial crisis? How does the phenomenon get started, and what propagates it?

I'm teaching a second-year PhD course, which is basically financial crisis economics. I gathered together a set of papers, some of which I had seen, and some of which were on conference programs, the key filter being that these papers had to have been somehow inspired by the financial crisis. The list includes two of my own papers, one of which is not quite ready for public consumption (maybe in a month or so).

Here's an idea that struck me in class last Thursday. There are basically two ways to think about financial crises, or the process by which financial factors affect aggregate economic activity. The first is indeterminacy. This is the basic idea behind Diamond and Dybvig's (JPE, 1983) banking model. A bank run, or a panic, is a bad equilibrium. There is a good equilibrium in which the panic does not happen, but there may exist an equilibrium where everyone wants to run to the bank to withdraw his or her deposit, under the self-fulfilling belief that everyone else runs to the bank. The paper by Ennis/Keister on my reading list (and their other recent work) gives you a nice summary of where the Diamond-Dybvig literature went.

The second process potentially driving a financial crisis is amplification - the idea that financial factors can amplify a small shock to the economy and make it a big one. That's the idea in the "financial accelerator" literature, which evolves from early work of mine (JPE 1987), Bernanke-Gertler (1989), and Bernanke-Gertler-Gilchrist. I think the upshot of that literature is that there is not much propagation. However, there's an idea in my JPE '87 paper that Larry Christiano has used empirically, which seems to get some mileage. In a costly-state-verification world (which gives rise to non-contingent debt under some circumstances), more risk will be bad even if economic agents are risk-neutral. Christiano measures the importantance of "risk shocks" for business cycles and finds that the shocks are important in general (and not just in the past 4 years).

What struck me is that my idea of what the real estate bubble was and Jim Bullard's view are quite different. My view is that the bubble was about amplification. A piece of the price of houses is always due to a type of "monetary bubble." Equity in a house is collateral which can be used by the homeowner to borrow; the mortgage on the house can be packaged as a mortgage-backed security, and that security can be used in financial exchange, and as collateral, perhaps multiple times. Thus, through an amplification effect, the housing collateral potentially supports a very large quantity of credit, and that feeds back into housing prices. The financial crisis was about incentive problems that caused the monetary bubble to be larger than was socially optimal, and once financial market participants caught on, that piece of the bubble burst.

Bullard's view is essentially indeterminacy. The real estate bubble was a self-fulfilling good equilibrium, and now we're in a bad one.

The two views get us to the same place. I.e. potential GDP is much smaller than the Old Keynesians are telling us. What you see may be what you get. However, the policy conclusions implied by each view could be quite different.

Addendum: See this paper by Dorofeenko/Lee/Salyer on how risk shocks are propagated through the housing sector.


  1. Stephen, a version of your amplification process was first described by Friedrich Hayek in 1929 in Book IV of his _Monetary Economics and the Trade Cycle_ .....

    Just sayin'

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  3. Good post. You might say that indeterminacy is an extreme form of amplification, where the positive feedback parameter exceeds one.

    1. Could be. I was almost thinking that the collateral story I'm telling could give you a model with indeterminacy.

  4. You may want to consider Ponzi games as part of amplification (and at some point of indeterminacy as suggested by Rowe). I mean ex-post Ponzi games, those in which a good guy becomes a bad one because either he rejects reality (he hires a new economic adviser to forecast what he wants) or he acknowledges reality but chooses not to take any loss (he hires a new accountant to report what he wants and perhaps a lawyer).

  5. John Carney of CNBC views this financial crisis as a case of money in the shadow banking system losing its value. See here:

    What do you think?

    1. Some Credit Suisse economists make similar arguments:

    2. Some of the Zero Hedge guys have also made this argument:


  6. In your post below you praised Lucas as a scientist, but as I pointed out, factual arguments exist to the contrary.

    Nonetheless, Lucas made him comments based on mere observation. Thus, I assume you must concede that mere observation alone can be scientific.

    If the is true, it seems to me that neither you nor Bullard are correct and that for insights we should instead look to those who have been the most successful applying economics over the last 40-50 years and that would be Warren Buffett and Charlie Munger.

    Munger's theory of economics is that it is the entirely the operation of the psychology of human misjudgment. His first principal is the economy is driven by winner's curse, that the actual accurate bid is the next to last bid, not the winner. Buffett and Munger so fear this misjudgment they will not even engage in auctions.

    Now, Daniel Kahneman has come out with Thinking Fast and Slow, which is Buffett/Munger on steroids.

    If the economy is what Buffett, Munger, and Kahneman describe, and thus without equilibrium, where does that leave your view or Bullard's view

  7. "A bank run, or a panic, is a bad equilibrium."
    Give me a break; that is no equilibrium! In general I have a hard time with this one equilibrium after another approach to economics. Just admit that it is dynamic and start over! Been reading Steve Keen, and enjoy his perspective.

    1. No, that's not what I think. I'm just describing what happens in a Diamond-Dybvig model. If I took the historical experience in the US and elsewhere on runs and panics, and wrote down a model to explain what was going on, I would not be thinking about multiple equilibria.

    2. OK, but if this is the alternative... "the idea that financial factors can amplify a small shock to the economy and make it a big one", it sounds like you are still starting out with an equilibrium assumption, but now with some "shock" to start things off. Again - Why can't we start with a system of equations that naturally have financial crisis as a possible outcome? Any "amplification" due to a debt "risk shock" sounds a lot like debt deflation - so why not include it directly?
      And it we are talking about indeterminacy, that will be the general nature of a dynamic system that depends critically on initial conditions.

    3. You seem to be conflicted. You don't like multiple equilibrium but you do.

    4. 'overly aggregated, completely uninterested in micro foundations and therefore worthless.'

      Of course this is an unbacked assertion about micro foundations being important.

      'Keen argues that neoclassical econ ignores debt. What a damn fool. The literature has been full of papers on debt, even before the crisis. Its just that Keen didnt read them.'

      Keen overstates his case but many neoclassical models *do* ignore debt in general, as 'one person's asset is another's liability'. The papers that incorporate debt generally do it on an ad-hoc basis.

      All in all, Keen's empirical evidence is just too ample for me to disagree with him on debt.

  8. I don't think Gary knows very much about economics. He might want to stick to something easier, like arithmetic.

  9. e·qui·lib·ri·um   
    a state of rest or balance due to the equal action of opposing forces.
    equal balance between any powers, influences, etc.; equality of effect.

    I just don't see the economy as being in a "state of rest or balance"; rather it is a reactive complex system that responds to numerous external and internal state changes.
    Equilibrium implies a natural return to the undisturbed state. I just don't see the real economy acting that way.

    1. You are confusing "steady state" with "equilibrium", which is a common problem with physicists, for example. The steady state is a single point in the equilibrium process where the state of the world remains unchanged. Outside the steady state -- that is, pretty much everywhere -- things are changing all the time.

    2. Gary,

      Yes, as anonymous is pointing out, in modern dynamic econmics, we can think about equilibrium systems that fluctuate and grow. They may fluctuate and grow in response to exogenous shocks, or they may fluctuate and grow endogenously.

    3. it seems to be that using "equilibrium" to describe something not in equilibrium, as that word is commonly understood, is at best "misleading"

      This is especially true because of the policy implications of admitting the truth which is that the economy is never in equilibrium.

      IOW,this is not science, it is a word game, no different than Greenspan's "with notably rare exceptions" caveat.

      It is one thing to use technical jargon. It something else entirely to use words that are misleading or to use words in a misleading way, having one's fingers crossed so that one can later claim, well according to such and such a paper, black = white.

    4. Just because you don't understand the language of economics doesn't make it deficient, it makes you deficient. Lots of people think irregardless is a word, but they're as wrong as you are.

    5. 1) I understand the language of economics

      2) I also understand when one is being misleading and deceptive

      3) to use a common word and give it a meaning the polar opposite of its common use is deceptive and misleading, especially when on goes to Congress or writes for the public

    6. "I understand the language of economics."

      That is wrong, or misleading, deceptive, or whatever. You really do not understand what an equilibrium is. You need some more training.

    7. I understand what "equilibrium" is in plain english and I understand how "equilibrium" is misused to describe an entirely different state in economics.

      The issue is why did economists start misusing the word "equilibrium"? The answer does not lie in science, for their are better words for describing the intended idea or concept.

      The answer is that it permits economists to mislead and make the political argument that there is no need for regulation because "markets" will return to natural state of being in balance,etc.

      In fact, the opposite is true. Man is not an economic rational actor, but is driven by the psychology of human misjudgments. Markets do not return to any "natural state," and there is an ongoing need for regulation.

      IOW, the misuse of the word is intentional framing of a larger and very real political argument (and really not about any science at all).

      No honest person would ever describe markets as being in "equilibrium." Similarly, no honest person would credit the idea of the efficient-market hypothesis. Both are word games, not science.

    8. Does the world "relativity" as used in physics have the same meaning as in "plain English". No! You may want to read "Fashionable Nonsense: Postmodern Intellectual's Abuse of Science" to see what happens when people fail to make that distinction. Does this makes physicists dishonest? Give me a break! If you want to talk economics bother to learn to use the language properly, and stop blaming everyone else, post after post, for your deficiencies.

    9. "I understand what "equilibrium" is in plain english and I understand how "equilibrium" is misused to describe an entirely different state in economics."

      A statement more demonstrably false has rarely been committed to e-paper.

    10. Here is Alan Greenspan, economist, back as a free market evangelist, and it’s rather wonderful to read him describe economic equilibrium:

      Today’s competitive markets, whether we seek to recognise it or not, are driven by an international version of Adam Smith’s “invisible hand” that is unredeemably opaque. With notably rare exceptions (2008, for example), the global “invisible hand” has created relatively stable exchange rates, interest rates, prices, and wage rates.

      It is amazing to see people so dedicated to promoting dishonesty. Why is it so hard to say the truth: markets are never in equilibrium?

    11. "markets are never in equilibrium?"

      Really? So when you go to buy milk, bread, gasoline, and so on you keep witnessing shortages of some items and surpluses of others? Or did you have the old Soviet Union in mind?

      Of course in SOME markets frictions do prevent the equilibrium from being reached. Three ECONOMISTS won the last Nobel price for shedding light to the role of frictions in the labor market and defining an "equilibrium level of unemployment". Look, you have an issue with Alan Greenspan, that's fine. Why don't you take it up with him and stop busting our chops?

    12. "Why is it so hard to say the truth: markets are never in equilibrium?"

      Why is it so hard to say the truth: Anonymous doesn't have any idea what he's talking about.

      See, I can do it too.

    13. Ok. Let say we agree to repeat after you that "Markets are never in equilibrium."

      Where does that leave us, exactly? Does such wordsmithing give you added insight into how good or bad outcomes are? It does not.

      Please understand this: Equilibrium in economics does not imply that equilibrium is a nice outcome. For example, "Equilibrium" output levels under monopoly, you will recall are generally not good even by the standard of pareto optimality. Most Nash equilibria of games will also fail this test, and so on...

    14. The argument is about framing the debate.

      If markets are not in equilibrium, one has gone a long way toward making a very convincing case for regulation

      Conversely, if markets are guided by the invisible hand toward equilibrium then ...

      Someone gets right to the point with this comment.

      Look, you have an issue with Alan Greenspan, that's fine. Why don't you take it up with him and stop busting our chops?

      The reason I am busting chops is that people trusted this "profession" to bust Greenspan's chops and its didn't.

      I guess what keeps me adding a comment is a less re-learned from a David Bruck piece this week in the NYT when he complains that insanity has taken over the GOP because all the rinos are really opossums.

      This blog is an oppossum Blog. Williamson defends Lucas, Taylor, Cochrane, Greenspan like there is no tomorrow, leading Economics of Contempt to write:

      After reading John Taylor and John Cochrane's analyses Lehman's failure, I'm beginning to understand how it's possible for economists to say that "we're still arguing about the causes of the Great Depression." It's generally hard to come to an agreement when one side simply lies, or refuses to acknowledge undeniable facts.

      Two my cents is that the economic "concept" of equilibrium is a lie, a refusal to acknowledge undeniable facts.

      I realize I am beating a dead horse, but economics will have no use or benefit until it becomes truthful and long after that gains public respect. Today, the public correctly sees only opportunism. You have lots and lots of people and their crap that need to be thrown from the temple, like money changers. As long as Taylor, Greenspan, Cochrane, Lucas, all Hayekians and Austrians and lots and lots of others.

    15. You cannot frame a debate over something you, and many of those you read, do not understand. The proof is in the following sentence you wrote:

      "This blog is an oppossum Blog. Williamson defends Lucas, Taylor, Cochrane, Greenspan like there is no tomorrow,"

      You group John Taylor and Alan Greenspan together, as if they profess the same policy. This means you have missed the exchange between them over Taylor's assertion that Greenspan made a mistake when he violated the "Taylor rule" by keeping the targeted federal funds rate below the level predicted by the rule Taylor has proposed and Greenspan's response that the Taylor rule is somewhat useful but should not be the only criterion on which the Fed's decision is based. So how can someone side with both when they do not even side with each other?

      The difference between your approach and those who criticize your comments is that the latter refuse to engage precisely in the tactics of the GOP. Use gross and unfortunate generalizations according to divide the world to "good" and "evil", declare that if you are not with us you are against us, and then go after the those who are not with you with ad hominem attacks. This is the point that people who think like that will never understand: That you can believe that Lucas is a good person and a great economist and still think he is dead wrong on some key issues.

    16. Tell me, oh so wise Anonymous. Are markets with inventories in equilibrium? What about markets with rationing?

      How do you know whether something is in equilibrium? You don't. So in the end you're forced to argue that people are stupid and that you know better than they do what they should be doing. I'd say fuck off, but that might be considered rude.

  10. Indeed,typically in modern macroeconomics, the variables of interest, in equilibrium, follow a
    * stochastic process,* not an unchanging or deterministically evolving process.

    The reason such an object is still called an equilibrium is that everyone is doing the best they can-- given their expectations for the behavior of others and for any outside uncertainty that buffets them (surprise man made events outside the model, the weather, policy surprises, etc).

  11. "We have some idea that there is something unusual going on - something we might see every 15, 20, or 30 years, say, in a given economy."

    Do you think that there were no financial crises from after the Great Depression until deregulation in the 80's because of the heavy financial regulation? That with heavy regulation you have the benefit of no financial crises?

    And if this is the case, do you think it's worth it to have strong regulations to prevent financial crises from occurring every 15-30 years?

    1. Look at Canada. I don't think you could say the Canadians have ever had a financial crisis. Is that heavy or light regulation? In some ways the US is heavier. It's just different regulation.

    2. Allright then, perhaps regulation (more than zero or a tiny amount) is a very important issue here. Perhaps it can really prevent regular crises, hardship, and loss. So there should be a good deal of study of how to regulate finance well.

    3. Of course you're stating the obvious, Richard.

  12. Richard--there is.

    Finance and financial intermediation are all about the study of contracts, and when and why particular forms are used. Mechanism design is the usual route to figuring out the tradeoffs involved. See the now-old book by Dewatripont and Tirole on bank regulation, for example: and there's been a lot of work since

  13. Prof. Williamson, thanks for posting your reading list. Helps those of us who do research in different areas catch up!

  14. Suppose we have two moneys, MBS's and cash. MBS's are somewhat better than cash because they pay positive nominal interest rate. Suppose MBS's suddenly disappear. Apart from the loss due to the need to use more costly cash to pay for transactions, why would this lead to a major recession? Is there something about the transition to the cash only economy that makes it particularly painful to get there? What would that be?


  16. Equilibrium is more like a balanced way of processing in dynamic models like you get what you pay for. We always get annoyed with this kind of thing as a freshman. But it's not that big a problem I think.

  17. Gees! Enough is enough! So much discussion about what equilibrium is and whether it exists is nonsense, or at least a waste of time. I like to think that the real world is always in some kind of temporary equilibrium. Things happen for a reason. There are always many forces at work and reality is expected to the outcome of those forces. This is not just a practical way to think about equilibrium. That our models are a simplification of reality is one thing, and an incomplete understanding of reality is another. If what we see going on is not an equilibrium, then what is it? Therefore, if there is a financial crisis, it's got to be an equilibrium in some sense rather than a deviation of it. For me, this unfruitful discussion about equilibrium is worrisome. And we economists are perhaps those to blame.