The discipline of economics in crisis. The credit crunch has exposed many economists’ most cherished ideas for the nonsense they manifestly are. With its theories in tatters, what now for the dismal science?
It looks as if the best bet is take a a few leaves out of some network science text books. Economies are complex networks, after all, although economists have failed to notice.
Until now! One of the first onto the network bandwagon is Nobel prize-winner Jo Stiglitz from Columbia University and a few pals who have been examining the Japanese credit network between banks and quoted firms in 2004.
Since the collapse of the bubble economy in the early 90s, the Japanese banking system has been going through a similar crisis to the one sweeping the west, so there is plenty to learn (not least of which is the time it can take to turn things around, although most western economists are ignoring this at present) .
The paper makes both heartening and frightening reading.
It is frightening for the shocking admissions the authors make about their understanding of the way network science relates to the economy. This is how Stiglitz and co describe the insight they gain from their work:
“As we shall see in the present work, Japanese credit market shows that the credit relations between banks and firms are scale-free, and the standard representative agent plus normal distribution framework is badly equipped for dealing with it. For instance, the failure of a firm heavily indebted with a bank may produce important consequences on the balance sheet, or the financial status, of the bank itself. If a bank’s supply of credit is depleted, total supply of loans is negatively affected and/or the rate of interest increases, thus transferring the adverse shock to the other firms. Therefore the study of structure of the links and their weights allows to gain some insights in the financial stability of the economic system and to develop new economic policy tools.”
No! Who’d have guessed.
(The paper is also frightening because both the abstract and concluding paragraph are gibberish, not being composed of proper sentences and lacking any grammatical sense. But this is a preprint, I suppose.)
The paper is heartening because the work seems to give the team an insight into how to tackle the crisis.
“Rather than looking at the “average” risk of bankruptcy, and to infer it would represent the stability of the system, the network analysis of the real system tells us to investigate the different sub-systems of the global economy and to intervene to prevent failures and their spread. Instead of a helicopter drop of liquidity, one can make “targeted” interventions to a given agent or sector of activity”
So the helicopter approach that central banks all over the world have been trying is wrong-headed.
Stiglitz and co seem to be saying that a targeted approach based on the structure of the network would be better. Of course what they are proposing would only work if they had a good current snapshot of the network as well as the expertise to analyse it correctly.
Sadly, economists seem to be lacking both.
Ref: arxiv.org/abs/0901.2384 : An Analysis of the Japanese Credit Network