The new Financial Macro-economy

The new Financial Macro-economy

Last week we celebrated the 2011 session of the summer workshop on economic theory (M-SWET 2011) in Madrid. As usual it has been a very interesting conference in general. But three articles have attempted to link microeconomics, macroeconomics and finance (one of them written and presented by a Nobel Prize winner, Roger Myerson), and I find it interesting to comment on them.

The new Financial Macro-economy

Because this coincidence is the reflection that economists are paying attention to what another Nobel Prize winner, Paul Krugman, recommended a couple of years ago: “make the maximum effort to incorporate the realities of finance in macroeconomics.” And not because Krugman said it, of course, but because it is what he has to do now.

As we discussed with Samuel Bentolila the other day, there are good reasons for the macro economists to have a certain clue in the past. Reasons that have nothing to do with Inside Jobs. Building a good model of macroeconomics, as a good climate model, requires simplifying some aspects of reality. We cannot introduce all the complications at the same time.

And since they were introducing imperfections in the markets, it seemed more reasonable to do so in the labor market, for example. Whatever the “ex-post experts” say, the financial markets present many characteristics of a frictionless market. He who does not believe it, who tries to earn money consistently anticipating what, happens in it. I had a lot of fun watching sophisticated mathematicians and physicists crash, thinking they were going to cover themselves by taking the fools who operated in those markets.

But this excess of confidence in the financial markets has taken its toll. And now it’s time to reform. The first example is an article by Jean-Charles Rochet, author along with Xavier Ferias of the most important textbook on the microeconomics of the banking system.

Rochet told us that empirical evidence shows that banks tend to lend too much during booms, and very little during recessions. For this reason, the banking sector aggravates, instead of cushioning, the shocks that are at the base of the crisis. His article proposes a simple explanation for this dysfunction of credit markets based on three characteristic ingredients of the activities of modern banks.

The first ingredient is moral hazard: banks are supposed to monitor SMEs that turn to them, but they can avoid this obligation, unless regulation allows them to obtain sufficient information rents. These rents make the amount that investors are willing to lend to banks a multiple of the capital of the banks themselves. The second ingredient is a high exposure to aggregate shocks: the assets of the banks have a highly correlated profitability. The third and final ingredient is the ease with which modern banks can reallocate capital between different lines of business.

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