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A Developing issue in Macro-Econometric Modeling: Stress Testing

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There is a developing issue in Macro-Econometric Modeling right now. It has been burning for about a year; we at asymptotix have some practical engagement with it which is reflected in our essay called 'Crowding Out 2'. That essay and its related comments simply document our experience at the client coal-face where we naively found ourselves addressing in a commercial engagement a great intellectual challenge of our time, probably way ahead of the academic curve. At a much more global and higher media oriented level this issue is documented in what is known as the Krugman / Ferguson debate or put more crudely (cf Niall Ferguson) the Keynesians versus the Monetarists (or more strictly the Classicists or Neo-Classicists).

asymptotix halmo sextantEnough of this "hi-follutin" ivory towers nonsense, what is this all about? Well it really boils down to building econometric models which DO NOT HAVE A FINANCIAL SECTOR. This is important! See my reference here, the Macro-Econometric models which were used by the European Commission to monitor the Stability and Growth Pact did not include a component which modeled the Financial Sector. See my conclusion on AMECO to my comment on my blog; "The Point about Stress Tests".

What I was trying to get at there; although I did not make it explicit was that in building a Stress Testing platform which is robust and has integrity one could harness a reduced form ("summary") of the DG ECFIN real economy model to another model of the Financial Sector and thus produce a powerful model of your own to drive any form of Stress Testing or Risk Capital estimation (or indeed any type of Quantitative activity you need including buy side fundamental analysis). Effectively by taking as input the ECFIN models you could build in-house a better more complete macro-econometric model than ECFIN ran to monitor Stability and Growth in the Euro area. (Here a rough sketch)

But of course implicit in my new idea is a rather important criticism of activities in the European Commission over the last twenty years in the crucially important responsibility of monitoring the Stability and Growth Pact. That Directorate General was discharging its responsibility on the basis of economic models of the individual member states and the aggregate euro area which did not include a component which modeled or informed the model about the performance of the financial sector either of the member states or of the aggregate euro area. If you want to understand the (relatively) ancient intellectual history of the type of modeling being undertaken in DG ECFIN and indeed the some of the mindsets within the European Central Bank see my discussion of that topic

asymptotix stress testingAs we all now know the blow-ups in Greece, in Ireland and imminently in Portugal all triggered in the Financial Sector but how could the European Commission or indeed the member states at the highest executive level have 'seen that coming' if all the advice they were getting from their Directorate General of Economic and Monetary Affairs (DG ECFIN) was predicated upon inadequate if not downright negligent macro-econometric modeling approaches. The same applies to 'Crowding Out'; if you have a macro-econometric model which robustly models the Financial Sector then you can clearly see going forward that Sovereign debt issuance is without question Crowding Out private sector demand for Capital; you don't need to get knotted up in the Feldstein-Horioka Paradox to understand that 'beggar my neighbor' attitudes to Capital are inevitable within the Eurozone itself. If you do not model the Financial Sector then you cannot know that and thus all your publications (quarterly, occasional or otherwise) are just total nonsense dressed up in a fancy badge, words without content; rubbish! Not only that; 'have been for years'. This explains why all that research output from DG ECFIN telling us Euro-integration was on-track or Macro-Economic numbers in the Eurozone were 'turning up' continuously spewed out from that ancient steam engine, even though one look outside the window would tell you that sort of thing was nonsense. Is that sort of process negligent? I'll leave you to decide. But remember that research was the basis of advice to the Council of Ministers during the crucial years; '07, '08 and '09!

Its obvious from the asymptotix website that I have no time for a lot of the decisions taken by various Directorate Generals of the European Commission in regard to maters Monetary and Econometric, my blog about "Lunatix on the Grass" and the consequent European Stablilization Bank proposal (which now seems to be about to be adopted) are evidence of that!

But we cannot avoid the fact that the European Commission is changing the Financial Services Landscape forever. Is it doing that without a robust comprehension of the Financial Sector of the European Economy or of the individual member states, without a decent model as it were? If so, that would be worrying. But if such an important executive body or bodies are so behind the curve that they cannot see blow ups in the Financial Sector in rear-view mode nor Crowding Out oncoming then how on earth are they going to be able to see this paradigm shift in Macro-Econometric modeling coming upon us now? Asymptotix does not want to grouchily criticize from the sidelines, this deconstruction can be read as a proposal, we would like to help, we think we understand the problem and we think we know what needs to be done to fix it. Please feel free to contact us if you wish to discuss this.

Why am I writing this now? Obviously it's not something which has come to me in a flash! Indeed I remember nearly falling off my chair two years ago with laughter, talking to a dear friend of mine, an economist by profession; when I first explained my discovery that the European Commission was running macro-econometric models of the Euro-are which did not include a Financial Sector component. It's not funny now is it? It's not an academic, hi-follutin matter is it? This is SERIOUS! I am writing this now because I am sure of my facts and not only that there is a momentum of thought now out there in publication from recognized and respected people which supports my view being expressed here and which I have held for a number of years that we need a paradigm shift in macro-econometric modeling if we are to be able to govern ourselves with macroprudential integrity going forward. Let me explain the content of this momentum.

In the United States its fair to say that great thought leadership is being exhibited by "Reinhart and Rogoff"; I was led to a quotation from them by this piece of work which begins the analytics necessary to understand the issue but in my view does not go far enough. This is the quotation;

Surely, the Second Great Contraction - the financial crisis of the late 2000s - will have a profound impact on economics, particularly the study of the linkages between the financial markets and the real economy."

But where the penny dropped for me was in reading the Financial Stability Review (FSR) of the European Central Bank of December 2010 and in particular a Special Feature (SF) in that FSR which is actually quite important for those of us interested in Macro-Financial (Prudential) matters related to Stress Testing; in that SF, the ECB makes the following telling point;-

"The global financial crisis has revealed important deficiencies of the standard macroeconomic models in capturing financial instabilities. Realistic characterisations of such instabilities include bank defaults, financial market illiquidity, extreme events, and related non-linearities. ............. None of these feature in the macroeconomic models regularly used for forecasting and monetary policy analysis and only recently has more emphasis been given to better developing the role of financial sectors in these models. This gap is of particular concern given the ongoing efforts to establish serious macro-prudential oversight and regulation to counter systemic risks."

The ECB is answering Rogoff's call! In that SF, reference is made to a speech by Jean Claude Trichet given just over a year ago at Clare College Cambridge; in that speech, Trichet spells it out; the speech went largely un-noticed until the FSR-SF was published in the "dark days" of the close of last year; its only 'anoraks' like me who would notice. Let me conclude by quoting what Trichet was thinking about that afternoon;

asymptotix trig"Detecting systemic risks early is the task of macro-prudential supervision. I would like to focus on the analytical issues underlying this policy and stress three approaches, linking them to the three forms of systemic risk I discussed at the start of my lecture."

"First, there are large and complex financial intermediaries, or like-minded clusters of financial institutions, that play prominent roles in the financial system. We can describe them as particularly important "nodes" in the financial network, which stand out through their risk, size and interconnectedness. The full understanding of their individual on- and off-balance sheet exposures and their lending and borrowing to each other is a crucial element in assessing and containing risks of contagion."

"The economic models we have at our disposal at present do not capture necessarily all relevant dimensions of systemic risk. For example, despite progress in developing macro-stress testing frameworks, there are still limitations in how economic analysis captures the two-sided interaction between financial instability and the performance of the broader economy. Standard macroeconomic models often do not have a well developed financial sector and are linear in nature."

Asymptotix has been out in front advising that integrating inadequate old fashioned Macroeconometric models with in-house models of the Financial Sector is the way to go, for a number of years now. Since 2006 we have been advocating the holistic approach to Stress Testing and taking a lot of flak for it. We have even been recommending the tool-sets to get his done and our advisers and friends are on the same page as us, some of them also publishing advice on how to do this. We know how to do this and have been ahead of the curve for years, now we find our radical ideas being not only theoretically validated but politically and practically also. If you wish our assistance please do not hesitate to contact us. This is a major paradigm shift towards macro-financial modeling, it will drive the prudential supervision process for years to come, it takes expertise and experience to get it implemented, you cannot risk making it up as you go along or taking advice from consultants who neither understand nor believe in the necessity of it.














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