Three Dimensions of Economic Crisis: Theoretical, Empirical, and Policy Analysis in Business Cycles Prepared for IDEAs Conference on Re-regulating global finance in the light of the global crisis April 10, 2008 Ping Chen China Center for Economic Research at Peking University, Beijing, China Center for New Political Economy at Fudan University, Shanghai, China

Nature of Business Cycles and Economic Crisis Exogenous school Frisch (1933), Friedman & Schwartz(1963), Lucas (1972), RBC, Black & Scholes (1973) Endogenous school Marx, Schumpeter, Hayek, von Mises, Keynes, Minsky, Natural experiments The Great Depression ( ), Stock Market Crash (1987), Sub-Prime Crisis (2008-) Computational experiment Discovery of deterministic color chaos (Chen 1996) > Endogenous nature

Operational Implications of Exogenous/Endogenous divide Exogenous forces events driven by random walk or white noise time series uncorrelated history does not matter! no internal/historical constraints to government policy! Endogenous forces events driven by wavelets time series highly correlated history does matter! strong internal/historical constraints to government policy!

Auto-Correlation Function for Deterministic & Stochastic Time Series

Different auto-correlations for Competing detrended time series

Equilibrium Illusion created by First-Differencing (High Frequency Noise Amplifier Whitening Filter) in Econometric Analysis Frequency response for the FD filter X(t) = FD[S(t)]=S(t+1)-S(t)

Evidence of Strange Attractor in Stock Market Obtained by WGQ transform (Wigner transform + Gabor space + Qian algorithm) Time-Varying Filter

Stock Price Indexes (Standard & Poor 500) Fractal dimension = 2.5 Variance of color chaos = 69 %

Economic diagnosis: Exogenous(1973) vs. Endogenous events

Noise-Driven Cycles Frisch 1933 vs. Harmonic Brownian Motion Unlenbeck & Orstein, 1930 Wang & Unlenbeck (1945) Frisch model for American business cycles which would be damped in 5-20 years Chen 1999,2004)!

Frisch model Perpetual Motion Machine of Second Type Frisch was not the FIRST: G.E.Uhlenbeck and L.S. Ornstein, "On the Theory of Brownian Motion," Physical Review, 36(3), (1930). Frischs Informal conference paper: R. Frisch, Propagation Problems and Impulse Problems in Dynamic Economics, in Economic Essays in Honour of Gustav Cassel, George Allen & Unwin, London (1933). Frisch's promised paper, "Changing harmonics studied from the point of view of linear operators and erratic shocks," was advertised three times under the category "papers to appear in early issues" in Econometrica, including Issue No. 2, 3, and 4 of Volume I (April, July, and October 1933) but never appeared in Econometrica since Frisch never mentioned a word about his prize-winning model in his Nobel speech in 1969 (Frisch 1981).

The Principle of Large Numbers for Positive Variables More Micro Elements > Less Macro Fluctuations (Independent fluctuations may cancel out each other) S N =X 1 +X X N Relative Deviation (RD) =

Observed Relative Deviation Implied Numbers (Data Source: Fed. Reserve St. Louis) Real Personal consumption 0.15% (800,000) Real GDP: 0.2 % (500,000) Real Private Investment: 1.2% (10,000) Dow Jones Industrial ( ) 1.4% (9000) S&P 500 Index ( ) 1.6% (5000) NASDAQ ( ): 2.0 % (3000) Texas Crude Oil Price ( ): 5.3 % (400)

US Household & Firm Numbers in1980 and Their Capability in Generating RD Realistic Number and Potential Relative Deviations

Economic Implications from Principle of Large Numbers Household fluctuations contribute less than 10% of GDP fluctuations weak micro foundations in business cycles Small firm fluctuations contribute only about a quarter of GDP fluctuations Only public companies and giant organizations may generate large fluctuations in investment, which is 6-10 times larger than GDP fluctuations meso foundations of business cycles

Why Lucas is wrong about microfoundations and rational expectations? MISTAKE I. Lucas critique also applies to Lucas theory when relative prices move in pairs creates arbitrage opportunity Under rational choice between leisure and work, there is arbitrage opportunity among mass Example: shock > wage DOWN > many workers choose leisure > leisure price UP > some workers choose work instead > cancel out the rational mass effect under rational expectations MISTAKE II. Lucas model of island economy with N agents disguised model of representative agent system degree of freedom =3 individual degree of freedom is 3/N ~ 0! Counter example: Ideal Gas in physics, each particle has 6 degree of freedom system with N particle has 6N degree of freedom Conclusion: equilibrium illusion of self-stabilizing market is created by representative agent model in macro + FD whitening filter in econometrics

Dan Gilligan, President of the PMA(Petroleum Marketers Association) on Oil Price Manipulated by Financial Giants Did Speculation Fuel Oil Price Swings?? (CBS 60 Minutes, 01/12/2009) in 2000, Congress deregulated the futures market, granting exemptions for complicated derivative investments called oil swaps, as well as electronic trading on private exchanges. Volatility in price of oil per barrel within one year $67 $147 $45 even jump $25 in one day! Changes in demand & supply less than 5% Changes in price of oil larger than 100% In mid-June - end of Nov Congress investigation started > $70 billion speculative capital left future market demand of oil dropped 5 Price of oil dropped more than 75% to $ of oil contracts in future market controlled by speculative capital In past 5 years capital poured into oil market by Hedge Funds and Big Investment Banks: $13 billion $300 billions Large players Morgan Stanley, Goldman Sachs, Barclays, J.P. Morgan put hundred of billions of dollars in oil future market California pension fund. Harvard Endowment, and large institutional investors

Smith Theorem and Market Share Regulation Adam Smith Theorem: Division of labor is limited by market extent danger of monopolistic competition Hidden hypothesis in efficient market (invisible hand) unlimited market extent Real market Limitation of market extent and players Necessary of International anti-trust law not only for merge & acquisition but also for trading in financial market Disclose market positions in trading for big players

Policy Implications for Crisis Policy Traditional policy with too big to fail Take over failed companies by a bigger firm, such as Citigroup and Bank of America prediction: Citigroup and Bank of America would become worse Better competition policy under Principle of Large Numbers Breaking up AIG, Citigroup into competing firms improve chances of innovation and competition + diversify risk of wrong decision Examples: China broke up China Airline into several companies, Oligarchs in Russia

RD Behavior for Stochastic Models Random walk is damping over time Brownian motion is exploding over time Only the Birth-death process is stable in time > resilient market of endogenous fluctuations

Source of Financial Instability Nonlinear Trend & Higher Moments in Birth-Death Process Option pricing model based on nonlinear birth-death process Stability condition Under stability: finite first & second moment Ito construct arbitrage portfolio Black-Scholes model

Crisis Trend Collapse & Divergence of Higher Moments Dow Jones Industrial in Great Depression

Policy Constraints during Crisis International coordination Danger of trade protection, asymmetric investment, and competitive devaluation Domestic constraints: Expansionary monetary policy danger of inflation, devaluation, and capital flight Expansionary fiscal policy danger of new bad loans, crowding out small & medium healthy firms Finding new source of growth structural adjustment green economy

References Coase, R. H. The Firm, the market, and the Law, University of Chicago Press, Chicago (1990), Coase, R. Social Costs (1960). Frisch, R. "Propagation Problems and Impulse Problems in Dynamic Economics," in Economic Essays in Honour of Gustav Cassel, George Allen & Unwin, London (1933). Friedman, M. The Case for Flexible Exchange Rates, in M. Friedman, Essays in Positive Economics, University of Chicago Press, Chicago (1953). Friedman, M. and A.J. Schwartz, Monetary History of United States, , Princeton University Press, NJ: Princeton (1963). Lucas, R.E. Jr. "Expectations and the Neutrality of Money," Journal of Economic Theory, 4, (1972). Minsky, H.P. Stabilizing an Unstable Economy, Yale University Press, New Haven (1986).

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