Guest Post: Anticipating Financial Instability – High Time for a Coherent Macroeconomics

Rob Parenteau, CFA, is sole proprietor of MacroStrategy Edge, editor of the Richebacher Letter, and a research associate with the Levy Economics Institute.

At a Brookings Institution session last March, while Bear Stearns was flaming out, Robert Rubin asserted “few, if any people anticipated the sort of meltdown that we are seeing in credit markets at present.” Der Spiegel recently carried an insightful piece on one of the few, former central banker William White (,1518,635051,00.html). White and his protégés at the BIS – the central bank for central banks – like Claudio Borio repeatedly stuck their necks out to warn of the financial imbalances building in the global economic system. In contrast, most of their colleagues in central banks, backed by the prevailing mainstream macroeconomics, mistakenly asserted that inflation stability would insure both stability in economic growth and financial stability. Indeed, this was part of the narrative that central bankers like Chairman Bernanke took up with their Great Moderation story.

Similarly, Nassim Taleb has gained notoriety for his view that the recent episode of financial instability is an example of a Black Swan event – a type of “tail event” that will randomly disrupt human affairs because we tend to systematically clip off the extremes of the possible when examining the range of likely outcomes. Yet a recent paper by Dirk Bezemer at Groningen University, “No One Saw This Coming”, however, documents that dissenting voices were there to be heard, if one was only willing to listen (

This in itself is not entirely surprising – after all, financial markets require bulls and bear if any trading is to actually occur, and there is always a contingent of knee jerk contrarians, misanthropes, and malcontents known as permabears willing to spin the doom and gloom narrative. However, what Bezemer uncovered is that an identifiable common thread ran across the dissenting views.

The dissenters, Bezemer found, shared an emphasis on a stock/flow coherent macroeconomics. That is, starting from what should be an uncontroversial, accounting based view that at the level of the economy as a whole, total income must equal total expenditures, and total assets must equal total liabilities, those who saw this coming were able to identify unsustainable sectoral cash flow and balance sheet developments. In advance, a stock/flow coherent macroeconomics revealed the reasons why the Great Moderation was bound, by construction, to eventually give way to the Great Disruption.

As Bezemer put it,

“Surveying these assessments and forecasts, there appears to be a set of interrelated elements central and common to the contrarians’ thinking. This comprises a concern with financial assets as distinct from real sector assets, with the credit flows that finance both forms of wealth, with the debt growth accompanying growth in financial wealth, and with the accounting relation between the financial and real economy.”

Having performed one such analysis for the Levy Economics Institute in 2006 ( and studied financial instability reports issued by the Levy Institute, the BIS, the IMF, and others prior to the recent financial crisis, we believe Bezemer has it largely correct. If policy makers are indeed serious about the “never again” pledge regarding a financial crises the size of the recent one, they will need to set aside the prevailing macroeconomic paradigm – one which has largely made itself irrelevant by approaching macro as little more than aggregated microeconomics. Instead, they will need to become familiar with a stock/flow coherent macroeconomics that highlights the way financial conditions can shape economic outcomes. This is an economics examined and utilized by J.M. Keynes, Irving Fisher, Hy Minsky, Wynne Godley, Kurt Richebacher, and others – it is an economics especially relevant to the world we actually inhabit.

When a plane crashes, investigators swarm over the site and retrieve the “black box” in order to determine the cause of the crash, with the aim of reducing the odds of future crashes. In that fashion, knowledge it built over time about what works and what does not work, and appropriate adjustment in technology or best practices can be made along the way.

Little in the way of such procedures appears to be set in motion following a financial crash. Given the ability of financial crises to disrupt the lives of more people than can fit on a plane, this should strike most people as somewhat cavalier, if not absurd.

Some, like Bill Black, have suggested nothing less than a modern version of the Pecora Commission should be launched ( We are no fans of witch hunts, but we do believe ignoring useful frameworks for understanding financial instability, and leaving applied analysis based on these frameworks essentially ignored or marginalized, is unlikely to benefit anyone except those who gain the most from manufacturing and milking serial asset bubbles. Any attempt at an autopsy of the Great Disruption must go beyond cataloguing the inherent fragilities of the financial instruments and specific market structures themselves, as well as the flawed incentive structures and ample room for fraudulent practices, to a serious examination of the unsustainable macrofinancial dynamics that were either ignored or simply explained away.

If macroprudential supervision or any such related effort at reducing the odds of systemic economic crises unfolding from financial instability is to be successful, the core analytics will need to be built around a stock/flow coherent approach macroeconomics. The ground work in this area has been already been done by the likes of Claudio Borio, Wynne Godley, Levy Institute research associates, and others working in financial stability projects within various national and international institutions. Without paying attention to unsustainable sectoral cash flows and the resulting balance sheet leverage building up over time, financial vulnerabilities that can trip up the entire economy – indeed, as we have seen, the entire global economy – will remain largely invisible to investors, entrepreneurs, and policy makers. Perhaps that serves the interests of asset bubble perpetrators, but after recent events, it is high time to question whether those interests should remain paramount.

Bob Rubin is right – a few people did see an episode of financial instability brewing. Dirk Bezemer is also correct – these people tended to share a common approach to viewing economic and financial dynamics. That this framework is not being used to explicitly inform solutions to the current crisis is dumbfounding. That attempts to reduce the odds of future episodes of financial instability may not incorporate this framework, which after all is grounded in relatively straight forward and uncontroversial accounting, is senseless.

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  1. Haigh

    How about publishing a dashboard page on Naked Capitalism that graphically depicts "unsustainable sectoral cash flows and the resulting balance sheet leverage" ?

    The best way to kill off a bad paradigm with a new one is for the new one to show results superior to the old one.

    It may take a few popped bubbles to get it right, but there is no better time than now to publish a V1.

    Shiller was recently interviewed and claimed Systemic Risk now is worse than it was in 2008. Does this new model support that?

    The world wide web will beat a path to the door of any dashboard that works. Policy makers will then have no choice.

  2. DownSouth

    @"…we do believe ignoring useful frameworks for understanding financial instability, and leaving applied analysis based on these frameworks essentially ignored or marginalized, is unlikely to benefit anyone except those who gain the most from manufacturing and milking serial asset bubbles."

    We must face the appalling fact that we have been betrayed by both the Democratic and Republican parties.
    –Martin Luther King, "Facing the Challenge of a New Age"

    History is the long and tragic story of the fact that privileged groups seldom give up their privileges voluntarily.
    –Martin Luther King, "Letter from Birmingham City Jail"

    It is the height of naivite to believe that the Goldman Sachses of the world will surrender their entrenched priviliges just because the theories that underpin them have been proven to be wrong.

    The men of power in modern industry would not, of course, capitulate simply because the social philosophy by which they justify their policies had been discredited. When power is robbed of the shing armor of political, moral and philosophical theories, by which it defends itself, it will fight on without armor…
    Reinhold Niebuhr, Moral Man & Immoral Society

  3. Anonymous

    Unbelievably good article. Thanks.

    It seems like there is a monotonous cry of 'new paradigm' at the top of each one of these bubbles, and it seems inconceivable that economists can choose to ignore the basics of macroeconomics, decade after decade, in favor of cheap money and further bubbles.

    This is great stuff, and with luck, these views will start to permeate both through the establishment, and to the people, though it may take people starting to go hungry before this happens.

  4. Francois

    Since I'm no economist nor a finance-trained pro, I can't claim to fully understand the concept of stock/flow coherent macroeconomics.

    However, I've been trained (some would say "whipped") to sort out order from chaos, signal from noise in highly charged situations. SO, if there is a common characteristic shared by several people that properly perceived and analyzed a situation that escaped the majority, chances are there is a good deal of validity in their approach.

    It seems that the first step in further studying and possibly integrating this framework into the mainstream is to repeatedly highlight the contrast between those who got it and those who didn't while presenting the trait (stock/flow coherent macroeconomics) that the victors shared but the losers did not. There will come a time when it will be perceived as plain dishonest to ignore this approach.

    The sooner this is done the better. We clearly need to "Think Different".

  5. Anonymous

    Nassim Taleb has gained notoriety for his view that the recent episode of financial instability is an example of a Black Swan event

    Taleb does not claim that the recent events were a Black Swan. In fact he feels they were definitely not a Black Swan because the crack-up was quite predictable.

    I've been pointing this out for close to years now: After each airline disaster/Shuttle disaster/engineering disaster there is a thorough investigation by an independent party, yet there hasn't been one investigation of the recent events in the financial markets.

  6. Lord

    Quite right. Whenever I hear that this was the result of people believing their incomes would double in 5 years, or people believing their wealth would double every 5 years forever, they are so preposterous no one can believe anything they say.

  7. Don

    It seems clear to me that most of the seers were afraid of Debt-Deflation, which we have, and, even worse, a Debt-Deflationary Spiral, which we've managed to avoid so far. Surely that leads to Irving Fisher:

    From my point of view, this schema has been the best lens through which to view this crisis. In fact, I interpret Fisher's views in a way that can help explain this oddity as a consequence of Debt-Deflation:

    "In a research note, Carson says job losses in prior downturns have been roughly proportional to the decline in gross domestic product. But in the current recession, the proportion of jobs lost is running about a third greater than the drop in real GDP."

    This is just one reason that Debt-Deflation is so scary. Job loss can vastly outpace the decline in GDP.

    Don the libertarian Democrat

  8. MacroStrategy Edge

    Haigh – Agree about the dashboard idea, and in fact have been wading through the various financial stability projects to gather a good working set that is also underpinned by coherent macro for a Ford Foundation project that is unfortunately overdue.

    DownSouth – I have no illusions that speaking truth to power can get you more than a new set of teeth. But history also suggests a clear view of what went wrong and what it takes to make it go right can help galvanize change. Otherwise you are just relying on personality cults, which tend to go horribly wrong.

    Thanks Anon1 – send the views around. People are already starving, or at least more are on food stamps. It is one reason I feel compelled to keep harping on these fundamental misunderstandings.

  9. MacroStrategy Edge

    Francois – If you know how to balance your checkbook, then you are on your way to a coherent stock/flow macro approach. If you get cash flow statement analysis (sources and uses), you are even closer, but I will see if I can post a link to some examples or related papers that might help reveal a stock/flow coherent approach.

    Anon2 – Taleb is belatedly coming around to a view that debt has something to do with the issue of financial instability, judging by his recent co-authored article.

    Good step in the right direction, but he needs to keep going, maybe read a little Minsky while he is at it. All of this stuff needs to be rediscovered – and quickly so.

    I suppose Black Swans events are "predictable" in the sense that the normal distribution in fact has fat tails which we fail to recognize until after the Swan has flown past our noses, and then we quickly try to forget we ever saw it.

    But that kind of predictability does not get us very far, does it? I would suggest we need predictability in the sense of understanding the underlying economic and financial dynamics common to episodes of financial instability…and in other than purely statistical terms as well. 2nd and 3rd moments of bell shaped distributions don't mean much to most people. But perhaps I am misinterpreting the thrust of Taleb's contribution.

    Lord – Agreed, there are some simple truths that should prevail, but don't when people get caught in the fervor of asset bubbles. What amazes me is the speed with which people are willing to forget about prior bubbles and suspend their disbelief. Under such conditions, perhaps by the time markets police themselves, too much leverage has been built up to unwind in any kind of orderly fashion. At a minimum, some independent assessment of the degree of financial instability in the system needs to be made available, if not brought directly in to policy deliberations.

    For example, after the past 18 months of trial by fire, any central banker who has yet to figure out that inflation stability is not the only kind of stability worth evaluating needs to take a long, well deserved vacation. Maybe even a permanent one.

    Don – Yes, Fisher got many of the moving parts belatedly (he had to be stripped of his theoretical illusions about market equilibrium by losing his fortune and his house in the Great Depression, but I admire his courage in facing the facts).

    His 1933 contribution is rich, but a bit of a jumble, and it takes until Minsky hit's full stride 3-4 decades later before we get a clearer statement of financial instability dynamics. With Wynne Godley a decade or so late, we get the financial balances framework more fully exposed.

    But unfortunately, most of these contributions have been ignored or forgotten as much of modern macroeconomics has gone retrograde, huddling itself into a corner of applied calculus with little practical relevance to the world we actually inhabit.

  10. Anonymous

    The economy is not a machine with a pilot. Until enough people learn to not "run with herd" these busts will continue and this one is far from over. Deflationary busts are rare and Charles Collins of the old Bank Credit Analyst studied them all. He stated that the conditions necessary for a bust could be in place for years before it happened and there was enough variation in these conditions from one bust to the next that knowledgeable people could conclude that this time it is different and a bust won't happen.
    Running with the herd was a good way for cave men to survive but it doesn't work in markets. It is laughable now that people are looking for something to blame it on.

  11. skippy

    My heart is some what cleansed by the statements above, to hear thoughts succinct to problems and resent events. Tends to keep the ancestor in me still.

    I would only add that, is not our system of government an ad hoc means of check and balances to spread to out risk (mankind's dark side, gravitational pull of wealth and power). Hell Alexander Hamilton even suggested a Monarchy due to the fear (lack of knowledge, ability to self inform, of the average citizen) in a true democracy.

    If the herd is uninformed will it not just follow the personality cults as referenced above. So until the common man finds the will to inform them selves, where will the force come from to wrest power from the oligarchs (over/unhealthy consolidation of power to a few). The psychiatry involved with addicts of power preclude them from self realization of their acts, when faced with empirical evidence to the contrary/unhealthy out comes of their deeds (see W Bush, GS club).

    Fixing the economic woe of today is much more than an effort to right the monetary ship. Must it not involve a change of men on the helm/decks, change in the command structure. I fear only a threat of mutiny, is the only form capable to effect change.

    Skippy…The need of a national razor, I hope not and tennis courts have had more than one purpose in history.

    PS totaly agree with above, can we please stop using mathmatics to regulate human activitys.

  12. Anonymous


    According to Bob Prechter this decline is a larger degree (order of magnitude) than most and the most recent of this degree is the 1720 bursting of the South Sea Bubble. A series of depressions ensued culminating in the real Tea Party and the meeting on Tennis court.

  13. Hugh

    This seems to put more emphasis on debt and I for one tend to see a poltical agenda behind that. I suppose this common thread depends too on whom Bezemer talked to. I know he didn't talk to me or those like me who see the real culprit in the collusion of finance, politics, and government to construct a paper economy with its
    securitization, fraud, bubblenomics, balance of payments deficits, moral hazard, de-industrialization, and yes, debt.

  14. tom a taxpayer

    High time? Yes, it's high time for criminal prosecutions. If you really want to know what happened to the financial markets, a Racketeer Influenced and Corrupt Organizations Act (RICO) investigation and prosecution is needed. Everything else is namby-pamy nonsense.

    Yes, it's high time for prosecutions to bring down the entire mob that raped and pillaged the mortgage industry, ruined the housing market, destroyed the credit system, endangered municipal financing, pension funds, and the banking system, sent the economy into a downward spiral, endangered the world financial system, and now extort the U.S. and the world to pay them billions in ransom or face the destruction of the world financial system and economy.

    Yes, it's high time for the prosecution of Goldman Sachs, AIG, Merril Lynch, and other Wall Street investment banks and brokerages, the NY Fed, Countrywide and the mortgage industry and the appraisers, and Freddie and Fannie, and Citi and the big banksters, and the rating agencies, and the federal co-conspirators at U.S. Treasury, SEC, OTS, and the Federal Reserve and Hank "the mole" Paulson, Ben "the bag man" Bernanke, Tim "the patsy" Geithner, and the members of Congress who took money to facilitate the criminal enterprise.

    This is a target rich RICO prosecution environment. Start anywhere. You don't have to be Sherlock Holmes to follow the billion $ bread crumbs from Hank Paulson to his Goldman Sachs family and other friends of Hank. And the criminal activities (fraud, Ponzi schemes, blackmail, looting of treasury, cover-ups, etc.) are continuing today.

    Yes, it's high time to prosecute the hundreds of criminals responsible for committing the greatest financial crimes in U.S. history.

  15. ronald

    Another post depicting a financial maestro's ability to end the worlds problems with more informed economic data and better models;
    if only we had listened the world economy could have been saved!!

  16. Siggy

    Keynes, Austrian, NeoClassical etal, its a dialogue. No one contributor to the dialogue has it entirely correct. Could you see the current distress coming? Yes if you looked at it with a view to see what was there. If you could not see the folly of granting loans to people who could not afford the loan, then you have a problem. You need to find other employment as you individually a threat to the welfare of your fellow man. And, could we stop talking about the financial markets and the 'real' economy. Money, Credit, the Capital Markets are critical players in the 'real' economy. Can you have a 'real' economy without money, some medium of exchange and account?

    The cause of the current problem of miss-allocation of resources is our ill conceived monetary system. A fractional reserve system is inherently insolvent. Every banker knows this. The bailouts are the result of the full knowledge that every major bank is fundamentally insolvent! Simplify the measure of required reserves. Make the required level of reserves very substantial, 30% to 50% of demand deposits and 15% of tangible equity. Write some laws to the purpose of: write a contract you can't honor and you go jail.

  17. Marcf

    I have looked at Keen's models in some detail. They try to give a trivial account of Fisher/Minsky moment. The Minsky moment is modeled as a dramatic slowdown in the velocity of money and results in a breakdown of the coupled linear differential equations that mimics the great Depression.

    In retrospect and in studying monetary theory I realize there isn't much in the field for the simple reason that the mathematics are non-linear coupled (dY=kY, 6 or more of them). There is NO WAY to explore these by SOLVING the equations, all you can do is mimic their dynamics in programs like mathematica.

    And here lies the reason why we are so clueless about money and repeat our mistakes: the theoretical framework of what money is and how it behaves is still underdeveloped because we just didn't have the tools.

    This crisis is a result of a deadly mix of ignorance, greed and malice.

    The main point of "stock/flow" is well taken although seems fuzzy in this presentation. You measure flow if you can't measure stock and stock is an integral of flow. Certainly MBS and other CDO's were flowing credit through the economy and were not captured as it was all shadow banking. The accounting view of bank's balance sheet was not the proper regulatory approach as it only captured stock of banks. Measuring flow out or stock of CDO's held is needed. But realistically until there is an open and transparent market for these securities we are grasping at straws.
    Second, naked CDS is an even more important narrative of the disruption, it builds a phantom stock of bad debt that materializes at once. These must be regulated out of existence quick as Buiter as called in the FT recently.

    Good article, I have enjoyed reading it and the comments. Keep it up!

  18. Marcf

    MacroStategy: thanks for "Wynne Godley" comment I need to discover that work. Also totally agreed that Hyman Mynsky's work needs to be rediscovered fast, it never really went away it seems, just a hush hush community focusing on financial doom dynamics, not exactly a career builder in the late 90's. Bernanke wrote a lot of the seminal paper on monetary policy impact but I do believe it missed most of the aggregate monetary mass pushed by the innovation of the private sector.

    On that note, I do not think that current work I have seen correctly captures the Minsky moment. For example I have yet to find an endogenous model of the ponzi dynamics, a model where the shock emerges from the equations. Right now they are injected. The minsky narrative is a linear progression of debt build up until cash flows can't follow because of random noise in asset prices. Keep in mind that at 50x leverage a 2% variation will wipe out common equity. That triggers a meltdown in equity markets. How do you model a breakdown in market liquidity?

  19. MacroStrategy Edge

    Anon – I agree economies are more like complex, adaptive, ecological systems that evolve over time, but that does not mean they cannot be influenced. Changing investor behavior is indeed important, and to do that, incentive structures will also need to be changed – among them, as others like Tom have commented, being the price paid for fraudulent activity. It is astounding to me that such prosecution has not begun, and the only thing I can think is that the victims are blaming themselves for playing along with the asset bubbles and getting burned.

    With all due respect to BCA, while we cannot identify the day asset bubbles will bust, we surely can identify unsustainable financial dynamics in advance, and it is time to recognize and use that capacity wisely rather than simply ignore it.

    Siggy – The monetary system no doubt played a role in the mess, but much of the credit expansion took place outside the banking system, so pinning the problem on fractional reserve banking may be misplaced. Again, incentive structures and instrument design were grossly skewed away from any kind of serious credit analysis.
    You couldn't analyze the individual loans in a CDO, and besides, you weren't supposed to, because it was a portfolio of supposedly diversified loans, and besides, maybe you held insurance or guarantees on some of the tranches, so what was the point of doing the analysis?

    Marcf – Agree the mathematical modeling of Minsky dynamics has yet to prove satisfying, although Steve Keen's work has gone far in that respect. The nonlinearities are of the essence, as there is no other way to capture the turning point dynamics. And even then, there is a social psychology element to these things which we may never be able to represent well mathematically. And as mentioned above, the search for ways around regulations and for financial innovation will always open up new areas for abuse and eventual financial distress. The prevailing perception was that financial markets can be left alone as largely self-regulating, and time and again, this has proven problematic at best, especially when incentive structures are skewed.

  20. juan


    if 'the equations' were able to capture the dynamics of a crisis of overaccumulation, the so-called shock would be seen in its emergence just as would the turn to speculative activities, the greater relative political economic weight of money capitalists and expansion of fictitious capital, and the limits to said expansion.
    but then the neoclassical and, it seems, most modern Marxist economists have never been able to deal with these as interrelated moments of the same general process.
    somewhere along the way a [applied] philosophy of internal relations was lost, possibly due to excessive emphasis on 'micro foundations' even by those who should have known much better.

  21. Marcf

    MSE: I spent some weeks looking at Keen's models, trying to put them into mathematica (that took a week alone). They are in fact very interesting.

    The models are theoretical representation of debt money (no central bank needed) with 6 variables linked through linear differential equations. Because it is in the nature of money to grow exponentially as we speak of interest rates, from an engineering standpoint, the coupling of pure exponential equations leads to unstable models at even 2 variables.

    The first thing I like is that the narrative of money is captured in a dynamic way through the differential equations. We are not solving for equilibrium. This assumes that money is a thing that lives in equilibrium. But money is unstable, all the time. It is always a dynamic equation. For those interested in Mathematica, this is equivalent to saying "there is equilibrium in money equations, they are be solved for zero" vs "There is no equilibrium in money equations. The best you can do is run in NDSolve given initial constraints".

    Keen's models adequately capture this non-linear brutality in the models. 1929 was a dynamic breakdown, these simple models offer a good framework to think about the modern theories of money. What I am really reading is that any financial instrument that couples exponentially (interest bearing debt money) will create complex dynamic systems whose behavior we have yet to understand. That and if the growth of monetary debt mass is ahead of real economic creation, then you have a problem. In other words, the problem may be an endogenous property of money as defined right now: fiat money with interest payments on all kinds of maturities. This is in line with the current call by Taleb to change Debt to equity right now. Debt assumes interest payment, equity shares as you go, but if you don't grow exponentially it is ok, you won't default, you share in what is there or not.

    Juan: no need for dogmatism. The studies referenced here does have a psychological foundation. Keen in fact inject shocks in his system by slowing down velocity of money in his agents by 30% which is a very psychologically driven assumption.

    The Minsky narrative is one of psychology, that debt will grow because it pays to lever until it doesn't and then market dynamics adjust down very fast. It is not modeled correctly today. A purely endogenous Minsky/Fisher model would have the ponzi dynamics as an emergent property of exponential money: it pays to lever on the way up, but it assures you will run into a cash flow barrier at the end, what happens then.

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