Lehrstuhl für Geld, Währung und Internationale Finanzmärkte

Project Discription

The Current Crisis in the Financial Sector and Deficits in Economic Research

The field of economics was caught completely unprepared for the current financial crisis. It thus seems to many that it has obviously ignored many important factors and relationships relevant to financial markets. The inability of economic models to recognize developments that exacerbate crises and to capture developments observed in the real world has led to a heated debate about methodological deficits in this field. Paul Krugman, a 2008 Nobel Prize winner, has stated for example that the last 30 years of macroeconomic and financial market research have been “spectacularly useless at best, and positively harmful at worst” (cf., The Economist, July 16th, 2009). Others have emphasized that economists are partially responsible for negligence of the distortions in the financial sector, since their prevailing models paint an illusionist picture of a financial sector that is perfectly frictionless. It has also been argued that their axiomatic approaches served, without being validated empirically, as the intellectual basis for the thoroughgoing liberalization of financial markets that has finally led to the current crisis.

In the prevailing macroeconomic models, the financial sector indeed plays only a very rudimentary role: the central bank sets the interest rate, which in turn affects the consumption and savings decisions of households. The actual actors in the financial sector and the many types of transactions made there do not really play a role in these models. Phenomena such as speculative bubbles, overinvestment, the effects of balance sheet changes and liquidity, and the domino effects of bank bankruptcies are excluded a priori. The origination of distortions in the financial sector and their spread to the real economy is not compatible with the basic structure of these models. The way the financial crisis has played out thus demands that macroeconomic research be given a new direction in many respects. On the one hand, the internal structure of the much differentiated global financial sector and its intrinsic destabilization potential need to be studied.

On the other hand, the spread of the crisis from the banking sector to the business sector needs to be studied. The former will be the primary object of study in the project proposed here, since the network structure of the financial sector is not well researched. Understanding these networks appears to be of central importance in analyzing systemic instabilities. It provides the scientific background for the much emphasized macroprudential approach to regulating the banking sector, an approach that is supposed to take into account not only bank-specific risks but also the system-wide risk factors currently ignored.

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Network Effects and Systemic Risk in the Banking Sector