In-depth analysis on Credit Writedowns Pro.

On debt’s centrality to modelling complex economic systems

The following video is about modelling economic data. The takeaway for me here is that modelling complex systems is hard to do. The standard approach in mainstream economics is to strip the system down to as simple a form as is possible without stripping out essential layers. The goal is to reduce the apparent complexity of the system in order to ascertain how its key determinants interact. The problem, however, is that this process risks stripping out determinative layers of complexity that render the model useless. If you listen to Bill White in the video from my 2010 post on the origins of the next crisis, you can see this is what he is saying.

My view as developed in that post is that debt is central to understanding economic systems, and not just because it has a redistributive element in apportioning losses between creditors and debtors when recession forces credit writedowns. More importantly, debt accumulation adds to an economy’s ability to sustain economic growth (and malinvestment) by adding to aggregate demand. That is to say, in modelling any economy we cannot treat credit supply as a constant dependent on available savings because, as I have recently remarked, “There is no natural check on the amount of credit that can be created under this arrangement” for credit in modern economies. Ostensibly, creditworthiness is the check on credit supply since financial institutions want to be repaid and so should not lend to debtors that cannot repay. You know the saying: “debts that cannot be repaid, won’t be.” The reality, however, is that people (and hence financial institutions) don’t operate this way. The profit motive is too great and animal spirits take over to force a business cycle irrespective of government intervention. I need to underline the last point because a lot of people act like central banks are the root of all evil when we know the business cycle pre-dates central banks and is endemic to capitalist systems.

In any event, I think the standard approach of simplifying complex economic systems leads to simplistic models that are inadequate for anyone interested in tail risk. And so we get blindsided by these 100-year flood like economic events every 5 years. There is a better approach. This video has some useful suggestions and talks about Steve Keen’s efforts to model economic systems. Take a look. It’s not clear whether the complex modelling approach works is something that will work either. We’ll just have to wait and see.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

7 Comments

  1. The methods of lines they use are great methods for illustrating concepts and complex systems can often be linearized and decoupled at a small region to take advantage of such presentation tools.

    However, considerations of debt and banks are probably taught in third or forth year courses if at all and consequently this very important dimension of economics is not taught to non economics and perhaps not even to many economists.

    I think there probably has been a lot of work in complex economic systems but I don’t know what percentage of the profession would participate in this. The problem is that such work hasn’t yet revolutionized our understanding in economics.

  2. Dave Holden says:

    What’s disheartening about Krugman’s posts on Keen is not that he disagrees with Keen, it’s that he clearly hasn’t read him. It’s not that he disagrees with Keen’s description of banking, it’s that he clearly hasn’t looked into it.

    I’ve seen similar silo mentality from other well known neoclassical economist bloggers. If some catastrophic event occurred in the world of physics or biology and ten to fifteen scientists predicted it based on their theoretical models, and all of those theories had a commonality, I’d think it a given to expect every other scientist to at least familiarise themselves with those models and that commonality. Apparently in Economics ignorance is beneficial career attribute.

    As a lay person you find yourself in an intellectual no mans land where those you’d expect to be well read and knowledgeable clearly aren’t.

    Keen puts it well here

    “There is a bizarre asymmetry in economics: critics of Neoclassical economics like myself read Neoclassical literature avidly, no because we agree with it—far from it—but because we feel obliged to understand why they hold to their counterfactual views on the economy.”

  3. David Lazarus says:

    The creation of bank credit can help stimulate an economy but the problem is that tax policy pushes such investment into bubble creation. The lack of capital gains taxes means that actual consumer demand is not necessary if they can benefit from an increase in credit to inflate a bubble. Though what is needed are increased capital gains taxes that do not impact manufacturing companies but kill off asset bubbles which are a drain on demand. Then an overall cap on credit. So that consumers do not get too indebted and that banks do not expand so much that they endanger the sovereign. You might need to secure that debt cap with capital controls, as banks expand abroad to continually grow even if the sovereign stagnates.

    • Dave Holden says:

      A lot has to do with broken risk weightings

      http://www.golemxiv.co.uk/2012/03/propaganda-wars-our-version-toxic-bloom-of-lies/

      But I agree on your general gist.

    • Dave Holden says:

      Also speaking of which

      dailycapitalist.com/2012/03/30/germans-channel-austrians-as-they-prepare-to-do-what-the-u-s-should-have-done-last-decade

      • David Lazarus says:

        I have always questioned the latest Basel accord. It is rigged to allow banks to look safe even if they are full of toxic debt. I do think that risk based models are great to fool regulators because they are so complex. So ban risk models and have very simple capital ratios. It makes banks much safer, because they cannot risk arbitrage. As for interbank deals being less risky than some companies that was proved so wrong with the numbers of banks that have collapsed so far.

  4. Yes, you’re right. Debt is a fundamental to the understanding of economic systems.
    I don’t understand the video because it leads to confusion between complexity and complication. Complex systems analysis are, in fact, very simple to understand, they rely simply on the first principles of economics without any additional assumption that can lead us into wrong conclusions. And it is not true that they don’t produce anything in terms of risk management. For example, is it correct to raise minimum capital levels to cover credit risk? Perhaps not, see this paper

    http://arxiv.org/abs/1103.0717

    (ok, auto promotion :), but I don’t have another example at hand) that shows that when we consider that people, banks, companies are not all equal and part of a huge equilibrium fluid (like we do in “gaussian” risk modeling) that is not true at all.