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Eight Prerequisites for a Better Understanding of the Contemporary Financial Crisis

What does an economist need for reasonably thinking about the financial crisis of our days?

I am asking this for two purposes. First, I hope that answering this question will help us focus our attention on the very core of the problem and avoid getting lost in the many aspects related to the unfolding of the crisis that are important but not crucial. In this context, the exercise may also be helpful for prioritizing what should be in our models. The second reason for my question is that I am currently contemplating how to reform economists' curriculum. What is it that we must teach students in order to help them becoming operational when facing the world, as we perceive it?

To clarify what I mean when I speak about "reasonably thinking about the financial crisis": I do not aim at understanding the crisis comprehensively. I agree with Dani Rodrik that we do not yet understand the economic crisis of the 30ies, and never will. In an attempt to be modest and accept the limits of our reasoning, I want to suggest two dimensions of a reasonable analysis that are, far from being sufficient for comprehensively dealing with the resolution of the crisis, nevertheless necessary for developing an idea what we have to deal with: The first one is the ability, at some historical instance, to conclude that we face a specific problem that, if unresolved, may lead to severe consequences. This may be - besides the economic distortions - social upheaval like riots, civil unrest, and perhaps even civil war, and war between states. The second dimension is the potential for advancing our understanding about some of the core aspects of this crisis.

Congruously, in my opinion, an economist needs eight prerequisites for being up to this challenge:

1. A good understanding of double-entry accounting. An economist must be able to read balance sheets and know that for each entry, there somewhere is a corresponding entry. In particular, that for each asset, there is a respective liability.

2. A basic understanding of how financial markets work: especially, how assets are being traded and how market prices of the most important asset classes are derived.

3. A basic understanding of accounting principles, especially about mark-to-market accounting.

4. A basic understanding of the rules how bank assets must be backed by equity, e.g., the rules of Basel II, or respective regulations.

5. Knowledge about how money is created, both on the level of central and commercial banks.

6. A rough idea about the way how financial players are interconnected with each other, and with players from the non-financial economy (in contemporary speaking the "real" economy, as if banks were not real).

7. A basic understanding of dynamic systems. This means the way in which variables interact with each other. Moreover, it means having an idea of converging and diverging oscillations, exponential dynamics, and stability and instability of fix points.

8. A basic knowledge about economic history, especially about the economic crisis of the 30ies.

That should suffice to be operational on the level of detecting our contemporary crisis and thinking about some of its main aspects. What is practically not helpful are concepts like a "representative" agent on the level of macroeconomic aggregates, be it a representative consumer, a representative firm, or a representative bank. It may be helpful to engage into thinking about economic agents out there so as to focus on aspects that play a key role in real world interactions, and the resulting economic dynamics. Or, to use the wording of Colander et al. (2010), the considerations of economist should be externally consistent, i.e. consistent with real world operations.

References

Colander, D., Goldberg, M., Haas, A., Kirman, A., Juselius, K., Sloth, B., Lux, T (2010): The Financial Crisis and the Systemic Failure of the Economics Profession. In: Kolb, R.W. (Ed.), Lessons from the Financial Crisis, New Jersey, 427-436.

Rodrik, D. (2008): Who Killed Wall Street? Project Syndicate,
www.project-syndicate.org/commentary/rodrik24/English

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Keywords
GSDP, Financial Crisis

14.09.2011 16:27

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Armin Haas

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