Conventional economic models failed to foresee the financial crisis. Could agent-based modelling do better?

MAINSTREAM economics has always had its dissidents. But the discipline’s failure to predict the financial crisis has made the ground especially fertile for a rethink.

Critics tend to agree on what is wrong with current macroeconomic forecasting. A hearing of the House of Representatives Committee of Science and Technology on July 20th targeted the “dynamic stochastic general equilibrium” (DSGE) models used by the Federal Reserve and other central banks. The hearing aimed to “question the wisdom of relying for national economic policy on a single, specific model when alternatives are available.” The Institute for New Economic Thinking in New York, which had its inaugural conference in April, has attacked many of the assumptions, including efficient financial markets and rational expectations, on which these models are predicated. These assumptions were clearly too simplistic. But there is less agreement on what should replace the old ways. ...

Looking at the dollar in the old-fashioned way

WHEN the Bretton Woods system was cracking in the early 1970s the price of a troy ounce of gold, in dollar terms, was raised in two steps from $35 to $42.22. This was, in effect, a devaluation of the dollar.

The authorities then still thought it worth expressing the shift in terms of bullion, rather than against another currency like the Japanese yen or French franc. In the 1930s Franklin Roosevelt had a specific policy of devaluing the dollar against gold, pushing the price from $20.67 to $35 in the belief this would push commodity prices (and thus farm incomes) higher and reduce the burden of debt service. ...

The latest Big Mac index suggests the euro is still overvalued

Correction to this article

ASK Western policymakers how they intend to squeeze growth from their sluggish economies and most pin their hopes on higher exports. That makes exchange rates an especially sensitive topic. A weaker currency improves the competitiveness of a country by making exports cheaper. It also encourages domestic consumers to switch from expensive imports to domestic goods. The Economist’s exchange-rate scorecard, the Big Mac index, shows that currencies continue to be cheap in the developing world but overvalued in Europe. ...

Getting Germans to open their wallets is hard

BERLIN’S supermarkets may not be quite as drab today as they were in the communist era, when party officials ordered that special care be taken not to “do anything that might awaken people’s needs”. But with their long queues, poor choice, baffling arrangement of goods and grumpy assistants, they still have a long way to go before they awaken anything but resignation.

Yet the state of Germany’s supermarkets is of far more than casual interest to outsiders. For when German politicians are urged to adopt policies to stimulate domestic spending and help revive flagging European economies, their standard retort is that there is little they can do to convince Germans to spend rather than save. Foreigners are often quick to dismiss this argument. They point, for instance, to the German economy’s weak service sector as an area of potential growth. Yet facts suggest that Germans really are more parsimonious than many of their neighbours. ...

Germany’s exporting prowess is leaving the rest of the euro area behind

FOR a moment in the spring, the existence of the euro seemed under threat. Strange, then, that during those weeks of deepening crisis, businesses and consumers exchanged euros for goods and services much as they had done since the currency was introduced. Indeed the euro zone’s economy was quietly expanding. Forecasters reckon that GDP grew at an annualised rate of around 2% in the second quarter, a decent number by European standards.

Fittingly for the country that gave most to bail out the euro zone, Germany did rather better. Its GDP growth rate may have been 4% or more. Business confidence in Germany certainly looks perkier. Orders for factory goods rose by a quarter in the year to May. The surge in new business has been good for jobs. In contrast to the trend in the rest of the euro zone, unemployment in Germany has fallen lower than even before the financial crisis. The job market has been helped by a short-time working scheme and flexible hours (see article). Many of the workers whose hours were cut have been quickly drawn back into full-time work. ...

The president’s push for more stimulus hits the buffers

BARACK OBAMA’S plea to stimulate economic growth now and cut deficits later got a mixed response from world leaders at the G20 summit in Toronto last weekend. And the reception back home was a lot worse.

On June 24th Democratic leaders in Congress withdrew a stimulus plan after failing, for the third time, to get the necessary 60 votes in the Senate to proceed. The defeat was all the more humbling because the bill had already been fiercely pared back. In his February budget Barack Obama had proposed $266 billion of new stimulus measures over the next few years. The “American Jobs and Closing Tax Loopholes Act” that Democratic leaders in Congress unveiled in May contained only $79 billion-worth: extended unemployment benefits, health-insurance subsidies for the unemployed and Medicaid grants to the states. (The entire bill would have added $134 billion to deficits because of extensions to expiring tax breaks and Medicare payments for doctors.) It was then repeatedly whittled down, finally to just $34 billion, in a vain attempt to win over a few Republicans. ...

E-commerce favours large companies but only because that is what people want

FOR as long as anyone can recall, chess enthusiasts in Cambridge, Massachusetts, have played on large streetside chessboards in the shadows of the stately buildings of Harvard Yard. But even in a place that seems impervious to the passage of time, there is change. One example is an empty space where a much-loved local institution, an independent bookshop called WordsWorth, stood for 30 years. Like small-business owners in other industries, its proprietors held the internet, of which the student-heavy populace of Cambridge were early adopters, responsible for having to shut up shop in 2004.

Everywhere people bemoan the replacement of the local and the quaint by outposts of big, homogeneous chains. But how true is the notion that the internet in particular has hastened the demise of some retailers, and that those it hurt were overwhelmingly small? A new study* on this subject by four economists at the University of Chicago looks at three industries—bookshops, travel agencies and new-car dealerships—for answers. They find much truth in the conventional wisdom, but also some solace for those who believe small is beautiful. ...

Both sides in the row over stimulus v austerity exaggerate, but the austerity lobby is the more dangerous

ECONOMIC policymaking, like hemlines, has fads. Last year the leaders of the G20 group of big economies led a global Keynesian boost, pledging fiscal stimulus worth a combined 2% of world GDP to prop up demand. At their most recent gathering, in Toronto on June 26th-27th, the club’s rich-world members pledged “at least” to halve their deficits by 2013. Though they left themselves wiggle room, the change of tone was clear. Thanks to Greece’s sovereign-debt crisis, which has terrified politicians, stimulus is out and deficit reduction is in.

The trend has been most noticeable in Europe, where every big economy has spelled out spending cuts or tax increases in recent weeks. But it is evident everywhere. Japan’s new prime minister, Naoto Kan, has pushed a debate about raising the consumption tax to the top of the campaign for the upper house of parliament. In America, Congress’s fears about the deficit have thwarted the Obama administration’s efforts to pass a new mini-stimulus (see article). ...

State-backed investors are coming back into the spotlight

WHEN markets are jumpy and cash is needed, sovereign-wealth funds have some very fetching characteristics. As well as having lots of money, they tend to make decisions quickly. During the financial crisis they pumped money, often ill-advisedly, into imploding banks. Now they have a fresh set of suitors. The Greek government has been wooing sovereign-wealth funds in the Gulf and Libya; this week it played host to a Chinese delegation. Agricultural Bank of China is thought to have lined up state-owned funds from Kuwait, Qatar and Singapore as cornerstone investors in its imminent listing. Sovereign funds may invest directly in the Asian insurance arm of AIG following Prudential’s failed bid.

Where sovereign-wealth funds invest, however, political concerns often follow. Funds have made some changes to the way they operate since they ploughed money into the banks. In October 2008, 26 sovereign-wealth funds, with support from the IMF, agreed to a set of accounting standards and investment practices called the Santiago Principles. The most significant of the 24 guidelines is the principle that the funds should comply with all the disclosure rules of host countries. Over the past year many funds have started publishing annual reports and disclosing their asset allocation, a significant step for a secretive sector. ...

American pressure for China to revalue the yuan is reviving. Others are less fussed

LIKE his leggier boss in the White House, Tim Geithner, America’s treasury secretary, is fond of basketball. In April he called a timeout in America’s long campaign for a stronger Chinese exchange rate, postponing a report that might have accused China of currency manipulation. His objective, he said, was to use his talks with China in May and the G20 gatherings in June to make “material progress” on rebalancing the world economy. The last of those meetings, the G20 summit in Toronto, will take place on June 26th and 27th.

In basketball timeouts provide an opportunity to regroup and substitute players. In politics they give new problems a chance to come into play. The Greek sovereign-debt crisis deflected the world’s attention from China’s currency and sank the euro, which meant the yuan has strengthened overall even as it has remained fixed to the dollar. It also unnerved China’s policymakers, who began to fret again about financial instability and a slowdown in the euro area, their second-biggest export market. This was not the time, they concluded, to fiddle with the yuan. ...

Financial firms bet on Republicans to fight for their interests

THE recession may have hurt, but re-regulation could hurt almost as much. So in the first quarter of this year the financial services, insurance and property industries spent nearly $125m on lobbying, up more than 11% from last year. The Centre for Public Integrity, a non-partisan research group, reckons the financial-services industries alone hired more than 3,000 lobbyists to influence the financial reform bill now before Congress. On June 14th came news that the Office of Congressional Ethics has launched a probe into the fund-raising activities of eight lawmakers who sit on the House Financial Services or Ways and Means Committees. They are thought to have held fund-raisers days before they voted on financial reform.

The bill has passed both House and Senate, but the two versions still have to be reconciled. Lobbyists hope to water down some of the more contentious provisions, such as a requirement for banks to spin off their derivatives units. They are making their appeals to familiar faces. The senators on the conference committee, which will meld the bills, are some of the biggest recipients of contributions from the financial services, insurance, and property industries, reckons the Centre for Responsive Politics. The 12 senators in question have received over $57m from these sectors during their careers. ...

America’s most profligate states do not owe as much, proportionately, as Greece. But their politics are just as problematic

THE state of Illinois has a rather crude way of coping with its ballooning budget deficit. It stops paying bills. Already, it has failed to pay more than $5 billion-worth. State legislators are paying their own office rent to avoid eviction. Schools and public universities are having their budgets cut.

Illinois owes Shore Community Services, a non-profit agency in suburban Chicago, some $1.6m for services to the mentally disabled. The agency has had to lay off a dozen staff. Jerry Gulley, the executive director, says his outfit’s line of credit could be exhausted soon. The bank will not accept the state’s IOUs as collateral. “That’s how sad it is,” shrugs Mr Gulley. ...

All the scenarios are painful, but some make more sense than others

FROM the outset Britain’s new coalition government has said that its main task is to tackle the yawning fiscal deficit, which hit a peacetime record of 11.1% of GDP in 2009-10. It will set out its plans in an “emergency” budget to be presented on June 22nd. The decisions made by George Osborne, the Conservative chancellor of the exchequer, working with Danny Alexander, the Liberal Democrat at the Treasury in charge of controlling spending, will be momentous, determining, perhaps, the government’s own longevity as well as Britain’s economic prospects.

In practice the budget will have to take into account the compact between the Tories and Lib Dems, as well as each party’s election pledges. But in principle this is an opportunity to start afresh, sweeping aside their own commitments and plans inherited from Labour, and learning from the experience of other countries that have had to impose big clampdowns. The question is how to close the fiscal gap while protecting a still delicate economy, securing public support through a distribution of pain that is seen to be fair. ...

Is China’s labour market at a turning-point?

ON JUNE 7th strikers at a rubber factory near Shanghai clashed with Chinese police. “The smell from the rubber is unbearable,” a migrant worker told the South China Morning Post, “but we don’t even get a toxic fumes subsidy.” On the same day Honda suffered a strike in a factory that makes its mufflers and exhaust parts, less than a week after it settled an earlier dispute by offering a 24% pay rise. On June 6th the owner of Foxconn, an electronics-maker, said that workers at its Shenzhen complex could earn 2,000 yuan ($293) a month from October if their work was up to scratch, about double the basic pay it previously offered, following a string of widely publicised suicides.

China is known for its plentiful, pliable workers. But these incidents have cast doubt on that caricature. In March Arthur Kroeber of GaveKal Dragonomics, a consultancy, declared the “end of surplus labour” in China. Three years earlier, Cai Fang of the Chinese Academy of Social Sciences argued that China, a country of 1.3 billion people, would soon run short of workers. ...

The G20’s budget cuts are less reckless than many fear. Be worried instead by the paucity of structural reforms

YOU could be forgiven for believing that a great change in global economic policy has just taken place. Judged by the statement released after their latest meeting, in South Korea on June 4th-5th, the finance ministers of the G20 group of the world’s biggest economies have ditched their collective commitment to Keynesian deficit spending. Unlike earlier announcements, including one as recently as April, the document makes no mention of fiscal stimulus to help struggling economies. Instead it argues that “countries with serious fiscal challenges need to accelerate the pace of consolidation.”

Some politicians, mainly from Europe, hailed the shift. Germany has been calling loudly for greater fiscal prudence. George Osborne, Britain’s new chancellor of the exchequer who is readying his country for fiscal frugality, crowed that the G20 had come round to his way of thinking. Many Keynesian economists are aghast, arguing that savage budget cuts will fell a fragile recovery and condemn the rich world to deflation. Paul Krugman, a columnist for the New York Times, wrote in his blog of the “utter folly” of “madmen in authority”. ...

Even if governments could create inflation, they may not want to

IN THE short run inflation is an economic phenomenon. In the long run it is a political one. This week The Economist asked a group of leading economists whether they reckoned inflation or deflation was the greater threat; this was our inaugural question in “Economics by invitation”, an online forum of more than 50 eminent economists. The rough consensus was that in the near term, as Western economies struggle to recover, the bigger worry there is deflation. But as the time horizon lengthened, more experts cited inflation, because it seems the most plausible exit strategy for governments trying to deal with crushing debts. “Deflation is not a lasting threat,” wrote Arminio Fraga, a former president of Brazil’s central bank. “The more interesting question is whether they can manage to keep inflation down over time under the regime of fiscal irresponsibility now prevailing almost everywhere.”

Creating more inflation is harder than it sounds—even if rich-world governments were tempted to try, as a solution to their fiscal problems. It requires aggregate demand to return to, and exceed, potential output. Measuring the output gap (the shortfall of actual demand compared with potential GDP) is notoriously tricky. The OECD reckons for its members it will be about 4% this year, down from about 5% last year. It has revised that estimate down since November in recognition of better-than-expected growth, especially in America. Still, the revised gap is larger than at any time since at least 1970. America’s gap was larger in 1982, but inflation today is much lower. Indeed, the OECD estimates that in each of the G7 countries, inflation will be less than 2% through to the end of next year. The process could be hurried up if inflation expectations rise. But with underlying inflation below central banks’ targets in many countries, and dropping, expectations could move down instead. ...

Rich countries must act to prevent prices from falling. That will cause problems for emerging economies

SHOULD you fret more about inflation or deflation? Few questions matter more for investors and policymakers, yet few seem so uncertain. Financial markets are sending mixed signals. Falling yields on Treasury bonds suggest that many investors worry about economic stagnation and deflation; the soaring price of gold points to fears of runaway inflation.

Economists also differ in their assessment of where the greater risks lie, depending largely on the country and time frame they are looking at. Judging by the discussion in a new online forum of more than 50 leading economists from around the world, which The Economist launched this week, deflation is the bigger short-term danger in big, rich economies, whereas inflation is an immediate worry in many emerging economies and, potentially, a longer-term danger in rich ones. ...

Just as business perks up after the recession, it is threatened by crime

FOR over a century Monterrey, in Mexico’s rocky and seemingly inhospitable north, has prided itself on being the country’s industrial capital and economic motor. It got rich making beer, steel, glass and cement. Today its quick access to both coasts of the United States enables it to export car parts, home appliances and aerospace components. At $16,000 per head, average income in the city of 3.7m people is twice the national average.

Last year this closeness to the United States did not seem like such a blessing. Mexico’s economy fared worse than any other in the Americas during the recession—it shrank by 9.7% in the year to June 2009—and its export-oriented north was the most affected area. In Nuevo Leon, the border state in which Monterrey lies, some 40,000 manufacturing jobs were lost in nine grim months from September 2008. ...

Governments were the solution to the economic crisis. Now they are the problem

IT’S not quite a Lehman moment, but financial markets are more anxious today than at any time since the global recovery took hold almost a year ago. The MSCI index of global stocks has fallen by over 15% since mid-April. Treasury yields have tumbled as investors have fled to the relative safety of American government bonds. The three-month inter-bank borrowing rate is at a ten-month high. Gone is the exuberance that greeted the return to growth (see article). Investors are on edge.

What lies behind these jitters? New nervousness about geopolitical risk, with tensions rising in the Korean peninsula, has not helped. But that comes on top of two wider worries. ...