Demands put on economic models for decision- making

Werner RoegerEuropean Commission/DG ECFIN

October 2010

Presentation prepared for workshop on development of agent based models for the global economy and its markets

The QUEST model Multi-Country Dynamic Stochastic General (DSGE) Equilibrium Model of the World Economy. The core model:

Representative household for each country/region. Fiscal and monetary authority. Households: use decision rules by optimising an intertemporal utility function subject

to an intertemporal budget constraint. Government: Empirically estimated spending and revenue rules, plus a debt

stabilisation rule Central bank: Taylor rule

Goods and labour markets: Subject to nominal and real frictions Financial markets: Perfect markets for domestic and foreign bonds.

Countries/Regions are linked via trade and asset markets

Country coverage: Flexible and depending on application. E. g.: An individual EA country vs. RoEA vs. RoW

http://ec.europa.eu/economy_finance/publications/economic_paper/2008/index_en.htm

Modelling needs: huge and diverse: (Non exhaustive) list of QUEST Model applications in 2009/2010:

Fiscal policies (SGP) Structural reforms (EU2020) Financial markets ( Capital regulation directive) Climate change (Copenhagen, EU Environmental Council) Internal and external imbalances (G-7, G-20, EU country surveillance)

Fiscal Policy: Evaluating fiscal stimulus package in EU countries. Analysing fiscal exit strategies Consolidation efforts of individual MS. Issues:

What is the size of the fiscal multiplier in a financial crisis (credit rationing by commercial banks, constrained monetary policy)?

How long should a fiscal stimulus last? What are the intertemporal tradeoffs of consolidation measures (short term cost vs.

medium term gains). What are the effects of rising government debt on sovereign risk premia, are interest

rates for private bonds affected? Model modifications:

Disaggregating the household sector into (credit constrained) borrowers and savers. http://ec.europa.eu/economy_finance/publications/economic_paper/2010/ecp426_en.htm

Structural Policies Dynamic macroeconomic effects of structural reform measures in: Goods market: Lowering entry costs, lowering administrative burden, increased competition, internal market related reforms (public procurement). Labour market: Benefit and transfer policies, skill composition, immigration Financial markets: improved access to venture capital, bank regulation Issues:

What are the (possible) short term costs and medium/long term gains of structural reforms.

What are the distributional effects (in particular on real wages). What are the budgetary costs (rate of self financing)

Model modifications:

Disaggregation of production sector into incumbents plus flow of entrants. Adding a research sector. Disaggregating employment into skill groups.

http://ec.europa.eu/economy_finance/publications/publication_summary13529_en.htm

Climate Change Macro impact of policies to reduce emissions (emissions trading , taxation) Issues:

Is there a double dividend Should governments stimulate emission reducing innovations?

Model modifications:

Disaggregate production into energy production and energy use Disaggregate energy production into 'clean' and 'dirty' Disaggregate energy using sectors into less and more polluting.

http://ec.europa.eu/economy_finance/publications/economic_paper/2010/pdf/ecp413_en.pdf

Financial markets Macro economic effects of tighter bank regulation Increased capital requirements Increased liquidity requirements. Issues:

How are bank lending spreads affected? How is loan volume affected? Is there credit rationing? Is the transition period granted by regulators important? What are the short and long run GDP and employment effects? Is there an effect on risk taking? Is volatility of GDP affected?

Model modifications:

Add a banking sector with bank equity. Model credit rationing. Disaggregate household into risk averse and less risk averse types.

http://www.bis.org/publ/othp10.pdf?noframes=1

Internal/External imbalances Causes and consequences of current account imbalances at a global level (China - US - EU - RoW). Causes and consequences of external imbalances in the Euro Area. Causes of the recent boom and bust in the world economy. Issues:

How do fiscal and structural policies affect current accounts? What is the role of currency risk premia? What explains the persistent imbalance of China and the US. How relevant is the savings glut hypothesis for explaining the US boom? The role of loan defaults in the current recession.

Model modification:

Further geographical disaggregation (adding China) Allowing for frictions in international financial markets. Allowing for bubbles. Distinguish between savers and debtors (+loan defaults).

Important in the current crisis. In a purely representative agent model a (mortgage) loan default shock could not generate a macro impact. http://ec.europa.eu/economy_finance/publications/economic_paper/2010/ecp397_en.htm

Notice: New policy questions and issues generally require some disaggregation of the model. Disaggregation is generally question specific. A disaggregation along all dimensions described above is not feasible given the hardware currently available to DG ECFIN. (it is questionable whether it is desirable)

In what direction should models be developed? 1) Existing models have strengths which should not be thrown over board easily.

-Optimising behaviour: Agents adjust their behaviour to new conditions. Simple rules of thumb will not capture this.

-Forward looking agents: Important for modelling savings and investment, asset markets.

Example 1: The debate about the Phillips Curve in the 70s. Wage setting models which were based on simple rules of thumb on the formation of inflation expectations predicted a systematic trade off between inflation and unemployment. This trade off turned out to be spurious and policy which tried to exploit this trade off ended up with higher inflation and no reduction in unemployment. Example 2: Effects of fiscal consolidation Simple Keynesian models predict far too large negative effects of fiscal consolidations (compared to empirical evidence). Models with fwd looking agents generate more reasonable results. 2) Current models capture well standard features of macroeconomic time series Mild fluctuations around a (stochastic) trend (with output gaps between -3 and plus 3% most of the time). 3) What is missing? Information processing capacity and heterogeneity of agents acting in asset markets (financial markets, residential investment) is likely to be overstated.

1) (Near) rational bubbles: This approach would stay closest to the current rational expectations framework and the efficient market hypothesis. There are two essential components of the EMH:

1. The price is right (Asset prices do not deviate from fundamentals) 2. There is no free lunch.

Thaler (professor of economics and behavioural science, U. of Chicago (2009): "Now, a year into the crisis, where has it left the advocates of the EMH? First some good news. If anything, our respect for the no free lunch component should have risen. Many investment strategies that seemed to beat the market were not doing so, once the true measure of risk was considered." "The bad news for EMH lovers is that the price is right component is in more trouble than ever. …. This does not mean it was possible to make money from this insight. Lunches are still not free. Shorting internet stocks or Las Vegas real estate two years before the peak was a good recipe for bankruptcy and no one has yet found a way to predict the end of a bubble." This suggests to me that models of asset markets must take into account that prices move in accordance with intertemporal optimality conditions, but finding a solution of the intertemporal optimisation problem satisfying the no ponzi game condition is often not possible. While rational bubbles may be a good general characterisation of fluctuations in asset markets but it offers little in terms of a description how these explosive paths can emerge.

2) Financial markets where agents can have heterogeneous beliefs: Optimists vs. pessimists. (Brock and Hommes (1998), De Grauwe (2008), Burnside et all. (2010)). Gradual information flows among agents, social dynamics (Hong and Stein (1999), Burnside et al. (20010)). Limited attention of cognitively overloaded investors (Peng and Xiong (2006)) Heterogeneous priors, overconfidence (Kandel et al (1995)) This approach could possibly better explain the persistence of certain deviations and possibly the self fulfilling nature of expectations. But also notice: These agents still solve sophisticated dynamic optimisation problems.

3) Heterogeneous agent models Models advocated by Shleifer et al. (1999) where agents differ by degree of rationality (e. g. Noise traders vs. rational (risk averse) speculators). In these models, at least a sub group of agents is a sophisticated dynamic optimiser. This remains necessary to fulfil the "no free lunch" requirement.

Boom:

FS and SG are not important for GDP growth because of offsetting effects on domestic and foreign demand.

After 2004, the stock market and housing boom supported growth in the US.

Bust:

Risk shock to investment and default are most important for the downturn in 2009.

The two most recent contractions are not caused by negative TFP shocks.

Boom:

ISTP can explain the level shift of I.

SG and FS add to this upward shift.

But: Excess volatility of I.

Two bubble periods.

dot com bubble: 1997-2000

bubble in 2004-2008

Bust:

Default shock adversely affects I from eof 2007.

Negative risk shock in 2008/09

Bursting bubble or panic?

Correction of overinvestment (2005-2008)

or

Panic in stock markets related to Lehman brothers (Sept. 2008)?

Boom:

FS and SG unimportant compared to housing bubble.

Bust:

Housing bust in 2006 preceeds the decline of US GDP.

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Figure 17: Shock decomposition: log housing investment to output ratio