Understanding financial instability through complex systems
This project is funded by the Netherlands Organization of Scientific Research (NWO) in the NWO Complexity program, 2010-2014 and carried out jointly with De Nederlandsche Bank (DNB).
The macroeconomic models used by central banks for forecasts and policy choices do not perform well in exceptional circumstances, as has become evident during the global financial recession. The president of the European Central Bank Jean Claude Trichet stated on November 18, 2010: “In the face of the crisis, we felt abandoned by conventional tools”. Their variety and flexibility notwithstanding, all of these models are centered around one equilibrium of similar and rational decisions by economic agents. Instead, the present research project focuses on the interaction of heterogeneous agents with limited knowledge or abilities, and the resulting dynamic behaviour of the system.
By considering the macroeconomic and financial system as a complex system, a new means arises to describe a change in the type of dynamic behaviour. The figure below is intended to clarify such a transition. Suppose the system is in a particular regime of dynamic behaviour represented by a ball in the left pit. Small shocks will not bring the system out of balance for a long time. However, when a certain condition of the system exceeds a critical value, the system will slide down to a completely different regime. In the figure this happens because the hump separating the two regimes gradually erodes. This nature of a regime shift, absent in the conventional models, has important implications for crisis management.
The highest ambition of the project is to explain economic and financial crises as the outcomes of critical transitions instead of external shocks. In this way attempts could be made to find critical values and discover problems within the system beforehand. Moreover, the attributed stabilising effects of financial institutions can be investigated. In particular, it is intended to analyse the interactions of banks and investors by imposing a network structure.
Naturally, the chosen research method cannot guarantee unconditional success. So far complex models have chiefly been applied to describe a single kind of financial markets. On the other hand, the commonly used macroeconomic models to a large extent abstract from the financial sector, which is assumed to be efficient. The project takes up the challenge to close the theoretical gap of complex financial instability.
Cees Diks, Cars Hommes, Marco van der Leij and Daan in’t Veld (UvA, CeNDEF); Wilko Bolt, Maria Demertzis and Iman van Lelyveld (DNB).