Traditional economic theory could not explain, much less predict, the near collapse of the financial system and its long-lasting effects on the global economy. Since the 2008 crisis, there has been increasing interest in using ideas from complexity theory to make sense of economic and financial markets. Concepts, such as tipping points, networks, contagion, feedback, and resilience have entered the financial and regulatory lexicon, but actual use of complexity models and results remains at an early stage. Recent insights and techniques offer potential for better monitoring and management of highly interconnected economic and financial systems and, thus, may help anticipate and manage future crises
The interconnectedness of the financial system is one of the main factors contributing to systemic risk. The financial crisis has shown how the network of intrafinancial exposures may, in times of systemic distress, amplify initially small shocks. In this work, the authors build on the DebtRank methodology by introducing the notion of a network of leverage and propose a two-round stress test exercise. In the first round, a shock hits banks’ external assets; in the second round, these initial losses reverberate in the network of interbank exposures because of the devaluation of interbank obligations. Losses in the second round result from a multiplicative effect between external and interbank leverage. The authors then apply the stress test to the largest EU banks for the years 2008–2013. They find that second-round losses are at least as large as first-round losses; neglecting these effects could therefore lead to a severe underestimation of systemic risk.
Building on previous works on business fluctuations, we model the propagation of financial distress in a network of regions, each populated by heterogeneous interacting firms and banks. In order to diversify risk, firm sell goods outside their own region and borrow from banks located there. However, this results in ties across regions which propagate financial distress across regional borders. We investigate how the average level of economic integration affects the probability of both individual and systemic failures. We find that the benefit of greater diversification is eventually offset by the effect of financial acceleration and contagion. In particular, beyond a certain level of integration the economy suffers more frequently from events with larger numbers of simultaneous failures.
This chapter starts by reflecting on the notion of "value" in economics. It then describes how economic decision-making models are framed and examines their moral dimension. The foundations of traditional economic decision-making models contrast with the emphasis of psychological research on the role of deontological considerations in decision-making. The focus is on a specific deontological value, so called "protected values". The chapter describes the main characteristics of individuals endowed with protected values in particular when these values focus on honesty, and reviews experimental evidence on the role of protected values for honesty in economic decision-making. Finally, some speculative thoughts are offered on the relevance of research on moral values for business policies, incentive design, and regulation. Also discussed are some open research questions regarding the role of moral values in economic decision-making.
Prior to the crisis the dominant paradigm in macroeconomic modeling was the micro-founded "New-Keynesian" DSGE model (described in many textbooks including the influential exposition of Woodford (2003)). In its most basic form this combines price-stickiness with forward looking decision making by both households and firms. This provides a tractable framework for capturing the response of output and inflation to both demand and supply shocks and explaining intuitively the transmission of monetary policy (with monetary policy characterized as a choice over rules for current and future interest rates).
The creation and protection of financial wealth is one of the most important roles of modern societies. People will commit to working hard and saving for future generations only if they can be sure that the efforts they exert every day will be rewarded by a better standard of living. This, however, can only be achieved with a well-functioning financial market. Unfortunately, a breakdown of the financial system as in the great financial crisis of 2007 and 2008 destroys the trust in this important social arrangement. To avoid such crises we need to improve our understanding of financial markets that, so far, has been built on totally unrealistic assumptions about the behavior of people acting in them. The most fundamental and at the same time the most questionable in modern economic theory is the hypothesis of full rationality of economic agents who are assumed to maximize their utility functions subject to their individual constraints, or in mathematical language, solve well-defined and precisely stated constrained optimization problems.
Central bank collateral frameworks are an often overlooked feature of monetary policy that play a key role in the monetary and financial system. Readers will discover how central banks conduct and implement monetary policy beyond merely setting interest rates, and develop their understanding as to how collateral policies may affect financial markets, financial stability, and the real economy. This book studies the collateral framework in the euro area in detail, and levers this analysis to provide an account of the euro crisis from the perspective of collateral policy. Readers gain access to a wealth of institutional and economic data and information with a level of density and accessibility unavailable elsewhere. This book, the first of its kind, is a valuable read for academic monetary and financial economists, those working in banking and policy-making financial institutions, and anyone who wishes to learn more about the role of central banks in society.
