New center on innovative economic thinking – University of Copenhagen

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20 April 2012

New center on innovative economic thinking

INNOVATIVE ECONOMISTS The global financial crisis has caused thousands of economists around the world to reconsider some of the basic assumptions of mainstream economics. The fundamental financial and economic imbalances that preceded the crisis pointed to the need for new models that may spot such imbalances and use them to provide a system for early warnings. The crisis also showed that we need to understand the inherent instability of markets better to be able to find solutions to the many economic and social challenges of today’s world. To address such questions, a new ‘INET Centre on Imperfect Knowledge’ was launched at the Department of Economics, University of Copenhagen, on Monday 16 April.

The aim of the Center is to develop Imperfect Knowledge based economic models that account for the inherent uncertainty of markets and its tendency to generate instability. Such models open up mainstream economic models to allow for the imperfection of knowledge and, hence, for the two-way interdependence between financial markets and the real economy.

The financial crisis has emphasized the importance of building economic models that can address questions such as: What creates instability in financial markets? How does the formation of expectations in a world of radical uncertainty contribute to instability? What are the perils of excessive leverage when an economic downturn sets about?

Increasing awareness

The crisis has been enormously costly, not just to wealthy financiers, but also to millions of ordinary people. That the consequences of recurrent financial and economic crises are dire was a basic motivation for establishing the Institute of New Economic Thinking (INET) in 2009. In the first two years of its existence, around 10,000 economists from all over the world joined the INET network demonstrating the increasing awareness in the economics profession that economics need new economic thinking to avoid this from happening again.

Professor Katarina Juselius- For several decades, leading mainstream economists, particularly in the USA, have built models with a mathematical precision that characterizes the natural sciences. The price for mathematical tractability is, however, that the models are based on many simplifying assumptions, for example that one agent represents the whole economy. However, economics is a social science which differs from natural sciences in the sense that economic outcomes affect and are affected by human behaviour. Under imperfect knowledge, such a reflexive process will tend to generate persistent deviations from long-run equilibrium states. Ignoring this very important aspect when building economic models is likely to lead to empirically misleading conclusions, explains Professor of Economics Katarina Juselius, the director at the new centre.

According to Katarina Juselius, it is important to develop a new type of models that can explain the prolonged imbalances, which are typical features of financial and macroeconomic data. Long persistent swings in unemployment and house prices are just two examples of macroeconomic consequences of booms and busts behaviour in speculative markets. To be able to tackle the economic and social challenges that the present crisis has underscored, it is, thus, important to obtain a better understanding of how financial markets and the real economy are interrelated.

The Danish Research Center

In close collaboration with Professor Roman Frydman from New York University, Katarina Juselius will initiate the development of empirically relevant models based on the more realistic assumption of uncertainty as a result of the imperfection of knowledge. With the launch of the Danish center, the fourth INET center in the world, the Danish researchers have joined the INET community where thousands of economists, ranging from Nobel Prize winners to students, participate in an open debate on economics.

Powerful financial markets

Katarina Juselius emphasises that market players base their decision on imperfect knowledge, and that economic models should allow for this uncertainty. The latter is important for understanding behaviour particularly in financial markets. Because most economic models do not include the behaviour of banks or speculative markets they are less useful as a basis for decision making in a world characterised by powerful financial markets:

- This became very clear in connection with the global financial crisis as most economists seemed unaware of the imbalances that had been built up before the crisis and, therefore, underestimated its severity. In the end, standard economic models had to be abandoned and the much-needed guidance for policy and regulation had, to a large extent, to be based on common sense. There was a widespread disagreement about the scope of the many rescue packages, whether they would be effective or not, and whether they would bring the economy back from the brink of disaster. Fundamental uncertainty reigned and political decision makers were largely caught off guard, says Katarina Juselius.

Focus on imbalances

The Danish INET center will engage in research that will help researchers understand the processes that generate financial instability. In particular, the self-reinforcing mechanisms that tend to produce prolonged booms and busts in the financial markets and the two-way interrelationship between the financial market and the real economy are of interest.

As examples of prolonged imbalances in the real economy that were associated with financial behavior, Katarina Juselius mentions the spell of low unemployment during the prolonged boom preceding the crisis and the high unemployment after the crisis erupted. House prices also showed a similar pattern; first by exhibiting a long period of excessive increases, only to experience a similarly long period of declining prices after the bubble burst. Such periods of very prolonged swings away and towards long-run equilibrium values are features of the data that are generally inconsistent with standard economic models.

Launching the Copenhagen INET Center

The Rector at the University of Copenhagen, Ralf Hemmingsen, opened the Center on 16 April in Alexandersalen, Bispetorvet 3, Copenhagen K. The opening ceremony was followed by a debate between Professor Niels Thygesen, chairman of the advisory board, and George Soros, the internationally recognised businessman and philanthropist, on the European debt crisis.

George Soros has also published several books on financial market behaviour in which he has emphasized the importance of imperfect knowledge and reflexivity, which are some of the basic ideas that the Danish INET center aims at exploring and further developing.