Michael D. Goldberg

THE FINANCIAL CRISIS AND THE SYSTEMIC FAILURE OF THE ECONOMICS PROFESSION

ABSTRACT Economists not only failed to anticipate the financial crisis; they may have contributed to it—with risk and derivatives models that, through spurious precision and untested theoretical assumptions, encouraged policy makers and market participants to see more stability and risk sharing than was actually present. Moreover, once the crisis occurred, it was met with incomprehension by most economists because of models that, on the one hand, downplay the possibility that economic actors may exhibit highly interactive behavior; and, on the other, assume that any homogeneity will involve economic actors sharing the economist’s own putatively correct model of the economy, so that error can stem only from an exogenous shock. The financial crisis presents both an ethical and an intellectual challenge to economics, and an opportunity to reform its study by grounding it more solidly in reality.

INTERNATIONAL FINANCE AND OPEN-ECONOMY MACROECONOMICS

The Basics.- Flow Approaches.- Stock and Stock-Flow Approaches.- The Exchange Rate.- The Intertemporal Approach.- International Monetary Integration.- Problems of the International Monetary (Non) System.- Appendices.

Macroeconomic Theory for a World of Imperfect Knowledge

We have recently proposed an alternative approach to economic analysis, which we call Imperfect Knowledge Economics (IKE). Although IKE builds on the methodology of contemporary macroeconomics by modeling aggregate outcomes on the basis of mathematical representations of individual decision making, it jettisons models that generate sharp predictions. In this paper, we elaborate on and extend the arguments that led us to propose IKE. We show analytically that in order to avoid the fundamental epistemological flaws inherent in extant models, economists must stop short of fully prespecifying change. We also show how acknowledging the limits of their knowledge may enable economists to shed new light on the basic features of observed time-series of market outcomes, such as fluctuations and risk in asset markets, which have confounded extant approaches for decades.

Empirical Exchange Rate Models and Shifts in the Co-Integrating Vector

Abstract This paper finds that many of the anomalies in the exchange rate literature can be explained in large measure by recurrent shifts in the co-integrating vector. We find that the co-integrating vector implied by a composite monetary model experiences parameter shifts on five occasions over the modern period of floating. Within the implied regimes of relative parameter constancy we find that parameter estimates are mostly significant and of the correct sign. We also find co-integration and considerable improvement in the out-of-sample fit on the part of all the structural models examined.

Theories, Consistent Expectations and Exchange Rate Dynamics

It has been apparent for some time now that the standard asset market models of exchange rate determination provide poor descriptions of exchange rate behaviour. These models are usually solved using the rational expectations hypothesis (REH) and it seems natural to inquire whether the problem lies in part with the expectational assumption. Studies that undertake this line of analysis in the exchange rate literature include Frankel and Froot (1987) and Kirman (1990). In this chapter we pursue this line of research and explore the implications of an alternative expectational assumption, recently proposed in Frydman and Phelps (1990) called the theories consistent expectations hypothesis (TCEH). We show that using the TCEH to close the monetary models of the exchange rate brings their implications more closely in line with the empirical record.

Testing Hypotheses in an I(2) Model with Applications to the Persistent Long Swings in the Dmk/

This paper discusses a number of likelihood ratio tests on long-run relations and common trends in the I(2) model and provide new results on the test of overidentifying restrictions on β’xt and the asymptotic variance for the stochastic trends parameters, α⊥1: How to specify deterministic components in the I(2) model is discussed at some length. Model specification and tests are illustrated with an empirical analysis of long and persistent swings in the foreign exchange market between Germany and USA. The data analyzed consist of nominal exchange rates, relative prices, US inflation rate, two long-term interest rates and two short-term interest rates over the 1975-1999 period. One important aim of the paper is to demonstrate that by structuring the data with the help of the I(2) model one can achieve a better understanding of the empirical regularities underlying the persistent swings in nominal exchange rates, typical in periods of floating exchange rates

Rate

Abstract This paper shows that the symmetry restrictions commonly used to simply the two-country, sticky-price monetary setup are not necessary for tractability as previously thought. The paper also shows that the practice of using these restrictions has obscurred the true long-run properties of the sticky-price setup. The paper shows that although one-time changes in money in the standard models of Frankel and Hooper and Morton lead to proportionate changes in the relative level of goods prices (i.e., domestic minus foreign), the absolute levels of these variables move disproportionately, with consequent movements in the steady-state levels of real interest rates and real money balances.

Symmetry restrictions and the semblance of neutrality in exchange rate models

We call attention to the class of models that serve as the foundation for the rational expectations hypothesis (REH). Models in this class rule out completely any structural change that cannot be fully anticipated with a probabilistic or other quantitative rule. REH models are abstractions of rational decision-making, but only in a hypothetical world in which participants can fully anticipate when and how they might revise their understanding of the process driving outcomes. We propose a new rational expectations hypothesis (NREH) as a way to represent rational decision- making in real-world markets. NREH builds on the insights of Muth (1961) and Lucas(1972, 2001) and imposes internal coherence between the economist’s under- standing of outcomes and that of the market. However, like Soros’s (1987) conceptual framework, NREH models recognize that any quantitative understanding of the process driving outcomes is necessarily provisional, eventually becomes inadequate, and thus requires revision. Consequently, NREH does so in the context of models that are partly open to unanticipated structural change. NREH models accord participants’ expectations an autonomous role in internally coherent models. They also incorporate REH’s and behavioral economists’ insights about the importance of fundamental and psychological considerations, without presuming that market participants are irrational.

Change and Rationality in Macroeconomics and Finance Theory: A New Rational Expectations Hypothesis

Shiller (1981) and others have shown that the quantitative predictions of the REH present-value model are inconsistent with time-series data on stock prices and dividends. In this paper, we assess the empirical relevance of the model without explicitly representing how a rational market participant forecasts dividends and interest rates. We find that stock prices are driven largely by news about fundamental factors. Moreover, this news moves prices through changes in the market’s forecasts of dividends and/or interest rates in ways that are remarkably consistent with the present-value model. We also find that the structure of the process underpinning stock prices undergoes quantitative change, and that both fundamental and psychological factors play an important role in this process. Taken together, Shiller’s findings and ours point to a novel explanation of the present-value model’s empirical difficulties. They also imply that macroeconomists and finance theorists should rethink how to represent rational forecasting in real-world markets.

New Evidence for the Present-Value Model of Stock Prices: Why the REH Version Failed Empirically

This note focuses on George Soross challenge to macroeconomics and finance theory that any valid methodology of social science must explicitly recognize fallibility in a Knightian sense. We use a simple algebraic example to sketch how extant models formalize fallibility. We argue that contemporary theorys epistemological and empirical difficulties can be traced to assuming away fallibility in a Knightian sense. We also discuss how imperfect knowledge economics provides a way to open mathematical models to such fallibility, while preserving economics as an empirical science.