Antoine Godin, senior economist of the French Development Agency and former associate professor of the Kingston University (London) delivered a lecture at a course of the MNB Department (New trends in economics). After the lecture Professor Godin gave an interview to Kristóf Lehmann (Head of the MNB Department) about stock-flow consistent models, dynamics of financialized economies, the Bank of England model development and about how he sees the economics debate 10 year after the crisis.
Kristóf Lehmann (KL): Professor Godin, you are a highly recognised expert in stock-flow consistent modelling. Could you summarize what SFC macroeconomic models can give us compared to other models?
Antoine Godin (AG): Stock-Flow Consistent (SFC) models are sectoral models of macroeconomies combining two fundamental insights: on the one hand, the economy is ruled by imbalances and reactions to these imbalances, and on the other hand, it is useful to represent the economy as an evolving and dynamic multi-layered network of financial relationships.
KL: What do you mean by that the economy is ruled by imbalances & reactions to these imbalances?
AG: Wynne Godley and others have shown the importance of building indicators based on sectorial accounts to highlight (im-)balances. Sectoral accounts are based on a fundamental concept: in an economy the sum of all sectoral net lending positions (savings or deficit) equals zero.
For one sector to run a surplus (i.e. to save), another sector in the economy or the rest of the world has to run a deficit (or dis-save). If a sector is running a deficit for a prolonged period of time, it will have to decrease the quantity of assets it holds or increase the quantity of liabilities it owes. Persistent imbalances are likely to trigger reactions from those sectors that are getting over indebted, or from sectors starved of assets for some period of time. Using these indicators, Godley correctly pointed out in in 1999 the U.S. was on an unsustainable path because there were persistent imbalances, particularly with respect to the rest of the world (i.e. the trade balance) and with respect to the private sector (i.e. households, firms and banks).
KL: Am I right that you are saying the economy is an evolving and dynamic multi-layered network of financial relationships?
AG: The second fundamental insight of SFC models lies in the observation that all actors in an economy are interconnected through their balance sheet. Each financial asset owned by a specific agent is also a financial liability for someone else.
For example, the deposit account of a household is both an asset for that household and a liability for the bank where the deposit is lodged. The same holds in reverse for a mortgage, which is a liability for a household and an asset for a bank. Financial assets thus create interconnections between the balance sheets of all actors. Actors then modify their behaviours as the size and quantity of interconnections evolves. For example, a bank that sees a decrease in reserves due to massive cash withdrawals is likely to change its behaviour by, for example, financing itself on the interbank market, increasing its deposit rate to attract more deposits or asking for advances from the central bank.
The combination of these two insights make SFC models a very effective tool to understand the dynamics of financialised economies and the interactions between real dynamics (e.g. the emergence of new sectors, products, technologies, decisions to invest in physical capital or consumption behaviours) and monetary/financial dynamics (e.g. macroprudential policies, interbank market or portfolio allocations).
Given the importance of transitions in economics (think of innovation dynamics, the emergence of socio-economic institutions or behaviours, sharp structural political or economic changes, or even the transition to a low-carbon economy), it is fundamental to be able to grasp how these transitions re-shape, create or steer imbalances and hence lead to unsustainable dynamics, which are difficult if not impossible to capture in more traditional modelling approaches.
One final note: SFC models, because they highlight the interactions between stocks and flows, are very close to system dynamics models, which are used in other contexts, such as representing the carbon cycle or ecological and agronomic systems. SFC models are thus an important tool to build technico-economic models linking economic dynamics and physical dynamics such as natural resources management, land use or climate change.
KL: Do you think that the usage of SFC models will spread?
AG: I think that the usage of SFC models will spread, especially if they are supported by innovative and prestigious institutions. The value of an approach is directly proportional to the questions it can answer. SFC models can answer questions addressing the interactions between the financial/monetary world and the real dimensions of the economy. The SFC approach highlights the importance of imbalances and disequilibrium. SFC models are thus particularly adapted to understand boom and bust dynamics which seem to be the norm over the last 10 years.
It is important emphasising a fundamental concept: the difference between the stock-flow consistent framework and the stock-flow consistent modelling approach. The SFC framework ensures that rigorous accounting is being enforced, which is true of many macro-models, and might be used to highlight feed-back loops between the real and financial spheres of an economy. SFC models combine the SFC framework with specific behavioural assumptions, often taken from the post-Keynesian school of thought, such as: limited rationality, fundamental uncertainty, non-optimising behaviours but also quantity-clearing markets, mark-up pricing or endogenous money creation. Both the framework and the modelling are extremely useful. In particular, SFC models, because of their specific behavioural assumptions, are to my understanding a fundamental tool to understand modern economies dynamics.
I have to stress the point, which I always make when I present SFC models. Building a model is not a goal per se but rather a means to beginning a dialogue, to help us to think and learn about specific dynamics. SFC models highlight some important dynamics but are ignorant of others. It is fundamental to have a plurality of modelling approaches and to have interactions between these approaches. So I am convinced that SFC models will spread but believe that neither they nor any other economic modelling approach should be dominant over other approaches.
Recently one of my colleagues started his presentation by a quotation from P.E. Box: “All models are wrong, some are useful”. I find important to highlight this point: we should avoid using models as normative tools but rather as descriptive or deductive tools. This is why it is fundamental that SFC modellers continue to interact with other modellers, non-modellers and even non-economists. It is by combining qualitative and quantitative insights that we can build models that are relevant and that provide answers that are useful.
KL: You always emphasize the so-called balance sheet approach. Why is that so important?
AG: As I explained above, SFC models are built on the idea that the economy can be perceived as an evolving and dynamic multi-layered network of balance sheet. This is such a helpful way to see the economy that it is hard to return to another way of thinking. The balance sheet approach is certainly not new, as many prominent economists have already stressed the importance of balance sheet to understand exchange rate impacts, the emergence of financial crises or of stagnation, and other phenomena. What is new is that SFC modellers apply them consistently, such that proposed models can be readily understood, adopted and critiqued.
As I try to apply it, the balance sheet approach fits within complexity theory as it highlights interactions and feed-back loops. This is crucial because the real world is complex, and overly simple answers to complex questions can bring more damages than benefits. There is no silver bullet when it comes to economic policy (or policy in general) and hence it is important to highlight as much as possible the nuances and feedbacks that a policy might have. As with Wynne Godley’s analysis of the U.S. economy before the financial crisis, constructing a financial balance sheet is a powerful tool to anticipate and adapt to feedbacks that would otherwise have been missed.
KL: What were the most interesting results of your projects at the Bank of England?
AG: We began building a dynamic model of financial balances for the United Kingdom in January 2014. The project is a collaboration between economists issued from different methodological approaches (DSGE, SFC, Complexity, Econometrics). The project addresses important economic themes: demography, housing markets, the banking industry and limited open economy considerations. The project was designed from the outset to be pragmatic and policy oriented. The goal was not to establish a superior model but rather trying to combine insights from various approaches or models into a model that could answer specific questions.
The aim of the project was to build a simple macroeconomic model based on the UK flow of funds (FoF) dataset, in order to facilitate macro scenario analysis. Our first Internal Bank of England project specification from March (2014) intended the model to be able to answer the following classes of question:
- ‘How do changes in the portfolio allocation of sector I affect financial stability and output?’
- ‘How do credit quality and funding shocks to banks affect the real economy and financial system, through supply of credit to households and firms?’
- ‘How does bank credit creation (including via mortgage lending) affect the evolution of the real economy and financial system?’
- ‘How do changes in demand in subsectors of the housing market (i.e. changes in the share of BtL / movers / FtBs) affect housing market dynamics and the broader evolution of the financial system?’
- ‘How do changes in import/export propensity affect the financial system?’
- Drying up of willingness of ROW to hold bonds” (Internal project specification, March 2014)
While the project was at first driven by theory, we soon discovered the importance of relying on data to highlight fundamental dynamics. The project’s main output was a model, described in a working paper published by the Bank of England (Burgess et al., 2016). “The paper aims to make a contribution towards filling in this gap in modelling imbalances, by developing a model with which we can assess how economic and financial imbalances are likely to evolve over longer periods, and whether such an evolution is likely to be sustainable for the UK economy. In addition, we can use the model to examine the evolution of financial balances under different scenarios and observe what the implications might be for monetary and macro-prudential policy over the medium term. We argue that such a model would form a useful addition to the set (‘suite’) of models called upon by policy makers to help them in their decision making.”
The three-year process of producing the module summarised in Burgess et al (2016) taught us that collaboration between people with different perspectives on the economy is key. It forces all partners to explain their own vision using words and concepts to which others can relate. It is only by starting constructive exchanges like these that macroeconomic theory will be able to overcome its current weaknesses.
The Stock-Flow Consistent framework, with its rigorous accounting rules, combined with a defined output and available macroeconomic data, allows us to structure the exchanges and ensures that specific concepts are defined in a coherent way.
KL: Have the lessons of the crisis been already learned by economists?
AG: Some lessons have been learned but I believe that most of the dynamics hindering the emergence of the great financial crises are still present and globally misunderstood. It is interesting to see how Hyman Minsky, for example, was highly regarded (even hyped) just after the crisis and how discussion of his ideas seems to have faded recently.
An important debate on the state of Macro is taking place, with contribution from many well-known economists. Unfortunately, even as the debate recognizes the weaknesses of the dominant macro-models, suggestions for addressing the weaknesses is taking place almost entirely within the existing macroeconomic framework rather than thinking outside the box.
Interestingly it is policy makers such as central bankers that are at the forefront of the debate and are pushing new alternatives. My sense is this will continue to be the case. My understanding is that this is due to their solitude when they were confronted with the great financial crises in 2007-2008. They had to implement policies in times which could not be explained by the then existing models and are now trying to find theories to judge whether they did what was needed or not. There has been tremendous work on trying to understand, analyse and incorporate the dynamics that led to the financial crises but I am not convinced that the lessons have been learned. Financial regulation is being questioned again; the roots of inequality have not been tackled; austerity and sound finance is ruling in Europe. It is thus very likely that a new financial crisis will emerge in the coming years. Combining this with the increased negative impacts of climate change, you can see that I am concerned about our future.
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