Did the financial crisis render economic modelling ineffective?

InnaGrinis
December,14
th
,2011

Thereisnodoubtthateachnewcrisisdemonstratesthelimitationsofexistingmodels,howeverit
alsocreatesagreatopportunitytoimproveandextendthem.Thisfinancialcrisisisnoexceptionin
thisrespect;notonlydoesitprovideaninterestingapplicationofsecondandthirdgeneration
models,butitshallalsorendereconomicmodellingmoreeffectiveinthefuture.

Uptodate,threegenerationsofmodelshavebeendevelopedtounderstandandseeksolutionsto
financialcrises.
Firstgenerationmodels,suchastheFloodGarbermodel(1994),explainhowdevaluationsare
triggeredbyexcessivereserveslosses.Theyhadbeensuccessfullyappliedtotulipbubbles,the
Germanhyperinflationofthe1920s,aswellasthe1982Mexicancrisis(BlancoandGraber,1986).
However,the19921993EuropeanMonetarySystemcrises,beingcausedbyspeculativeattacksand
politicaleventsinsteadofbadeconomicfundamentals
1
(Masson,2007),demonstratedtheir
ineffectivenessandledtothedevelopmentofthesecondgenerationmodels.
Obstfeld(1994,1996)refinedtheBarroGordonmodel,developedin1983,byintroducingtime
consistencyissuesandselffulfillingexpectations,thusmakingmultipleequilibriapossibleina
certainrangeofeconomicfundamentals.Fore.g.Jeanne(1997)hasshownthatthespeculative
attackonthefrancoccurredbecauseFrenchmacroeconomicfundamentalshappenedtobeinsucha
range.Ashiftininvestorsexpectationswasthedrivingforcebehindthedevaluation.
Letmetrytoexplaintheessenceofsuchmodelsbyapplyingasimplifiedversiontothecaseofthe
Europeandebtcrisis.Animportantfeatureofthemodelisthatpolicydecisionsinourcasethe
decisiontodefaultornotdependonbenefits(lowerinterestburden,fewerausteritymeasures...)
andcosts(reputationaldamage,higherriskpremiuminthefuture...).Moreover,benefitsfrom
defaultingwillvarywithinvestorsexpectationswhichthemselvesdependoneconomic
fundamentals.Ifthefundamentalsaresound,asinthecaseofGermany,investorsdonotexpectany
default.Onesinglegoodequilibriumemerges:nodefault.Ontheotherhand,ifthefundamentals
areharrowing,theonlypossibleequilibriumisthebadone.AnobviousexampleisGreece:its
growthforecastsfor2011and2012are6%and3%respectively,anditspublicdebtisexpectedto
peakat187%in2013(IMF).Theinterestingpartiswhathappensinthemiddleregion:isSpainstill
solvent?WhataboutItaly?Thisiswheremultipleequilibria,calledsunspotequilibria
2
,arise.

1
Economicfundamentalssummarizealltheexogenousstatevariablesthatmatter(Masson,2007).Fore.g.
theinitialdebtlevel,foreignexchangereserves,externaldebtshare...
2
Inthemiddle,therearesunspotequilibria,sonamedbecausethemodeldoesnotspecifywhich
equilibriumwouldbechosen.Instead,thechoiceisassumedtobedeterminedbyextraneousvariables,
sunspots.(Masson,2007)

Benefits,Costsofdefault

Benefits(defaultexpected) Benefits(defaultunexpected)

A
Costs
B

EconomicFundamentals
Forthesamelevelofeconomicfundamentals,whetherthecountrydefaults(equilibriumA)or
not(equilibriumB)willdependonwhatisexpected,i.e.expectationsbecomeselffulfilling.An
equilibriumisafixedpointinthereciprocalmappingbetweenthebeliefsofinvestorsand
policymakersactions.(Masson,2007)Butthelatterdependsonbenefitsandcostsofdefaulting.If
netbenefits(benefitscosts)arepositive,thegovernmentdefaults,otherwiseitrepaysthe
investors.Iamassumingforsimplicitythatdefaultcostsareconstantandthatbenefitsarean
increasingfunctionofeconomicfundamentals(intuitively,ahigherinitialdebtlevelwould
necessitatemoreausteritymeasuresinordertorepaydebt,sothebenefitsofdefaultingincrease).
Expectationsofdefaultshiftthebenefitsscheduleupbecauseasinvestorsdemandahigherrisk
premiumandareunwillingtolendmoneytothegovernment,debtservicingcostsincrease,making
defaultamoreattractiveoption.
Thedecisiontodefaultisthereforeendogenous:itdoesnotonlydependontheabilityofa
governmenttoserviceitsdebt,butalsoonitswillingness.Indeed,numerousexamplesexistwhere
countrieswithdebtlevelsaslowas47%(Mexico,1982)or50%(Argentina,2001)ofGDPdecidedto
default(ReinhartandRogoff,2009).
Bythesametokeninvestorsarecaughtinaprisonersdilemma:itisintheircollectiveinterestto
rollovershorttermdebtprovidingliquidityandavoidingdefault.Nevertheless,selffulfilling
expectations(sunspots)shifttheequilibriumandforcethecountrytodefaultmakinginvestorslose
money(J.Sachs,1984).Accordingtosomeestimates,theCitiexpectshaircutsonGreekdebtas
largeas76%!
3

Inamorecomplexsetting,itispossibletomodeltheprobabilityofdefault.Above,Iderivedthat
thegovernmentdefaultsifthenetbenefitsattimet(B becomepositive.However,B dependson
investorsexpectationsattimet1ofdefaultattimet(n )andtheactualexogenousstate
variables(b :
t
)
t
t-1
t
)
B
t
= b
t
+ on
t-1

(1)

3
Seethefollowingarticle:http://www.zerohedge.com/article/citiexpects76haircutgreekdebtand95if
countrywaits4yearsdebtgdpratiobackdown6
Theeconomicfundamentals canbemodelledastheexpectationattimetofthestatevariablesat
timet+1(investorscareaboutwhetherornotthecountrywillbeabletorepayinthenextperiod):
t
t
= E
t
b
t+1
e
t+1
= b
t+1
-
t
t
= pPi |B
t+1
> u]
=pPi |e
t+1
> on
t
+
t
](seeAppendixforthederivation)(4)
=p F|on
t
+
t
]
distributionfunctionoff(.).
t
below)arisebecausebothsidesof(4)
e
p the45linewherep = n,i.e.thegovernmentdefaults.

eis one bability, hereasfor threeequilibriaexist.

emerging
ou iessuchasBrazil,Chile,Columbia,thathadfundamen svaluesabovetheirrespective

betweenequilibriatriggeredbyacrisis
elsewhere(Masson,1999),hadtobeintroducedintoeconomicmodelling.
4
Thisiswhatconstitutes

(2)
Investorssurpriseattimet+1isthereforethedifferencebetweenexpost(realised)statevariables
andexante(expected)ones:
(3)
Furthermoresupposethegovernmentiswillingtodefaultwithprobability.
Theprobabilityofdefaultattimetishence:
n
WhereF(.)isthecumulative
Multipleequilibriaincertainrangesof (theredcurve
dependonn
t
.Expectationsofdefaultar thereforeselffulfillingsincethethresholdforthe
investorssurprisechangesastheprobabilityofdefaultvaries.

n
1
()n(')n
2
()n
3
()n

ther only equilibriumpro w For

Theineffectivenessofsecondgenerationmodelsbecameapparentinthe1990swhen
ntr tal

c
multipleequilibriathresholds,sufferedneverthelessfromtheTequilacrisisinMexico(19941995).
ThesameoccurredforMalaysia,SingaporeandHongKongduringthe19971998Asiancrises,
triggeredbythedevaluationoftheThaibaht(02/07/1997).
Tounderstandsuchcrises,contagion,definedasajump
theessenceofthirdgenerationmodels.Unfortunately,spacedoesnotallowmetoderivethe

4
ForamuchmorerigorousdefinitionofcontagionseeMardiDungey&DemosthenesTambakis(2003)
fundamentalequationscharacterizingthirdgenerationmodels,butinterestedreadersmayconsult
IFS
5
andEuropeanissues
6
lecturesbyDemosthenesTambakis,orPaulMasson(1997or2007
7
).
TheonlyequationIconsideristheinterestrateagovernmentpaysattimetinordertoattract
investorsfunds:
i
t
= i
-
+ n
t+1
o (S)
-
t+1
o
t+1
)
-
HerdingmodelsdevelopedbyBanerjee(1992)andBickchandanietal.(1992)studywhy,inthe
Irrationalcontagionisinvestigatedwithinbehaviouraleconomicsthatpayattentiontothe
thoughtpatternsthatanimatepeoplesideasandfeelings,theiranimalspirits.(Akerlof,Shiller).

Wherei istheriskfreeinterestrate,inourcasetheGermanone,andn canbeseenastherisk
premium,i.e.theinterestratespread,constitutedbytheprobabilityofdefault(n ando, the
percentageofmoneyinvestorswillloseinthecaseofadefaultattimet+1.
8

Thirdgenerationmodels,initiallydevelopedtounderstandemergingcountriescrises,are
extremelyusefultoseethedynamicsbehindtheEurozonedebtcrisis.AsDeGrauweargues:
membercountriesofamonetaryunionaredowngradedtothestatusofemergingeconomies.
Indeed,likeemergingcountriesthathavetoissuedebtinforeigncurrency,membersofthe
Eurozoneceasetohavecontroloverthecurrencyinwhichtheirdebtisissued.Thoughnorich
countryhasdefaultedsince1948,reversegraduation(Reinhart,Rogoff)fromserialdefaultis
neverthelesspossibleforEZmembers.Themodelsprovideamechanismthroughwhichasolvent
andhealthycountrycanbeforcedintoinsolvency.Thestartingpointisasuddenstopincapital
inflows(Calvo,1998).Investorsexpectationsshiftandtheyarenolongerwillingtolendmoney.
Aliquiditycrisisoccurs.
In1998,EastAsiasawa$33billioncapitaloutflow.Sincethemajorshareofdebthadbeenissued
indollars,asforeignexchangereservesdriedup,manygovernmentswereforcedtodevalue.
Outstandingdebtburdensbecomingunbearable,aseriesofbankruptciesfollowed.Butdefaultand
devaluationmodelsarecloselyrelated:insteadofareservesthresholdbelowwhichthecountry
devalues,wehaveadebttoGDPratiothresholdthatvarieswithtimeandstochastictaxrevenues
andabovewhichthecountrydefaults.Suddenstopsarethereforeextremelyrelevantinthecase
oftheEurozone:forinstanceGreeknetexternaldebtisexpectedtopeakat128%ofGDPin2012,
whichrepresentsabouttwothirdsoftotalGreekofficialdebtliabilities.
Contagionhappensthroughthreechannels:
_monsoonaleffects:globaleventsaffectingallcountries.Inequation(5)ifi rises,allEZmembers
willseetheirborrowingcostsincrease.
_purecontagion:shiftsinexpectations.
contextofasymmetricinformationanduncertaintyabouteconomicfundamentals,investorsprefer
toimitateothersratherthanrespondtoinformationavailabletothem.Inthiscase,contagionisa
rationalresponseonthepartofinvestorswhentherearefixedcostsofacquiringandprocessing
countryspecificinformation.(Dungey,Tambakis,2003).

5
Lecture4
6
Lecture3
7
Chapter3
8
Iassumeforsimplicitythatinvestorsareriskneutral.ForamorecompleteanalysisconsultD.Tambakis:
Europeanissues,Lecture3.
_spillovers:theprobabilityofdefaultn
t+1
ofoneparticularcountrywilldependonwhether
anothercountryhasdefaultedornot.Thiscreatesthepossibilitythatcountriestakentogethercan
s89%
sahigherriskpremium(DeGrauwe,2011),orwhyBelgium,withthethirdhighestdebt
toGDPratio(96.8%)inEurope,stillhasanAArating(S&Ps)?Thirdgenerationmodelsprovidean

dby17
re
ZgovernmentsspreadsmakingthetotalbillfortheEZ
ir
ngthelastdecade,andbeingunabletodevaluetoregainit,theyare
to
rth
odels?

ReinhartandRogoff(2009)thatmuchmoreattentionshouldbepaidto
bevulnerabletoattacks,whereaswhentakenseparatelytheywouldbeimmunetomultiple
equilibria.
OnemightaskwhySpainthathasadebttoGDPratiolowerthanthatoftheUK(72%versu
in2011)pay
answertosuchquestions.Whencapitalstartsflyingtoquality,governmentsfindthemselvesshort
ofliquidity.Beingunabletoprintmoneytorollovershorttermdebt,theyhavetoraiseinterest
ratestoattractmorefunds.Thisincreasesthedebtburdencreatingadevilishinteractionbetween
liquidityandsolvencycrises.(DeGrauwe).Thecountryistriggeredtowardsthebadsunspot
equilibrium,butthewholeEZisalsosweptalongintotheabyssbecauseofverystrongspillover
effects.Arezkietal.(2011)examinehowratingagenciesannouncementsinducefinancialinstability.
Fore.g.thedowngradeofGreeceonDecember,the8
th
,2009,notonlyraisedtheGreeksprea
basispointscostingtheGreekgovernment8.5million,butalsoraisedtheIrishspreadby5basis
pointsimplyinga2.5millionbillforIreland.
AonenotchratingdowngradeforFrancewouldcostitstaxpayers3billionperyear.Furthermo
itwillcertainlyhavelargespilloversonotherE
evenmoreimpressive.Aparadoxemerges:thesedeadweightlossesintermsofhigherdebtservicing
costscouldbeusedtoactuallyreducedebtlevels,butaresimplywastedwhileatthesametime
raisingdefaultprobabilities!
ThecoreproblemforsuchcountriesasGreece,Spain,Portugal,orItalyisthat,havinglostthe
relativecompetitivenessduri
forcedintoaninternaldevaluationconsistingofadeflationaryspiralandaprolongedrecession,
amplifiedbyausteritymeasures.Thismakestheireconomicfundamentalsevenworseleadingto
ratingdowngradesandfurthercapitaloutflows.Theviciouscirclecanonlybebrokenbyjumping
thegoodequilibrium.Manyinterestingideas,includingaEurobondssystemthatwouldavoid
moralhazardproblems,havebeendeveloped(DeGrauwe),butpoliticalreasonsimpedetheir
application.
Whatimpactwillthiscrisishaveoneconomicmodelling?Whatshouldbeincludedinthefou
generationm
HavingdiscoveredthefollowinggraphinaResearchPaperpublishedbytheSocitGnrale,Ishall
completelyagreewith
domesticdebtandoffbalanceitems.

Muchmoretransparency,historicaldataonpastrepayments,andactualdebtburdensatnational
andregionallevelsareneededinordertomakeeconomicmodellingmoreeffective.
Anotherfeaturethatthiscrisishasdemonstratedisthatastimegoesbyandnewcountriesare
infected;exitingthebadequilibriumbecomesarealchallenge.

2000words

Appendix:

Wehave:
B
t
= b
t
+ on
t-1

B
t+1
= b
t+1
+ on
t

t
= E
t
b
t+1

e
t+1
= b
t+1
-
t
Furthermoresupposethegovernmentiswillingtodefaultwithprobability.
n
t
= pPi |B
t+1
> u]
= pPi |b
t+1
+ on
t
> u]substituting(*)
Therefore: (*)
Theeconomicfundamentalsfunctionis:
Theinvestorssurpriseattimet+1is:
(**)
Theprobabilityofdefaultattimetishence:

= pPi
t
> u]substituting(**) | e
t+1
+
t
+ on
| e
t+1
> -(
t
+ on
t
)]
| e
t+1
<
t
+ on
t
]assuminganormaldistribution(symmetric)
p F|on
t
+
t
]

andShiller,R.J.,AnimalSpirits,2009;
Arezki,R.,Candelon,B.,andSy,A.N.R.,March2011:
eignRatingNewsandFinancialMarketsSpillovers: is,
Banerjee,A.,1992,Asimplemodelofherdbehaviour
eifer,D.andWelch,I.,1992,Atheoryoffads,fashion,custom,and
Garber,PM.,1986,Recurrentdevaluationandspeculativeattacksonthe
Mexicanpeso.JournalofPoliticalEconomy;
ises:TheSimpleEconomicsofSudden
Stops.JournalofAppliedEconomics;
11,CEPSWorkingPaper;
budgetfundamentalism,September2011,
RFWorkingPaper;
Edwards,A.andGrice,D.(GlobalStrategyTeam
dGarber,PM.,1994,Collapsingexchangerateregimes:Somelinear
examples.,JournalofInternationalEconomics
ofInternational
Masson,P.R.:
macroeconomicmodelswithmultipleequil
1994,CahiersEconomiquesetMonetaires,Paris,Banquede
;

.,andRogoff,K.S.,Thistimeisdifferent,2009;
ance,54.
Tambakis,D.N.:
,EconomicsTripos,Michaelmas2011lectures);
_EuropeanIssues(PartIIB,EconomicsTripos,Michaelmas2011lectures).
= pPi
= pPi
=
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