Trichet supports need for N Theory

Trichet in a speech at Harvard University cited a need for a better model to predict a financial crisis. In an article written by Justin Fox on March 22, 2012 for the HBR Blog Network, Justin reported on a speech given by ex-ECB President Jean-Claude Trichet before an audience at Harvard's Kennedy School. In his speech Trichet bemoaned the advice he received from economists during the Global Financial Crisis. He stressed that the most prevalent models (Dynamic-stochastic General Equilibrium models or DSGE) used by central banks were ineffective in predicting the turns in the Global Financial Crisis. He further stated that the assumptions underlying these models need to be challenged since the models failed to foresee that a disruption in the financial markets could cause a severe economic downturn.

Justin Fox quoting from a new book, The Assumptions Economists Make by Jonathan Schlefer, evaluates in the article whether the three leading economic theories are guilty of crimes against economic modeling. The first group of theorists to face the inquisition are the devotees of Rational Expectations. This theory which assumes the decision makers in charge of our financial affairs are omniscient and immune from missteps assigns a number of unrealistic abilities to the players in the economic game. It is assumed that knowledge of what is going on will enable these managers to sidestep disaster.

If that was always the case dodge ball would not be a fun game, since the game future is known. The other team is going to throw the ball back and try to hit someone with it. Armed with the knowledge of what the other side will do a player on your team will simply side step the incoming missile. Unfortunately, a player's performance differs greatly from what is predicted. Likewise, many knowledgeable players were knocked out of the economic game during the Global Financial Crisis even though they knew what was coming.

The Real Business Cycle theorists are the next group to go before the financial jury. The jury finds their predictions to be based on assigned human traits that do not fit with the reality of human responses especially during a panic or when the herd suddenly stampedes.

Finally, the judging panel returns to DSGE to evaluate why the most esteemed economic model did so poorly in the predicting the outcomes of the 2008 Global Financial Crisis. Schlefer concluding with the mildest of criticisms of Keynes and the DSGE models Keynes spawned was only found guilty of overstating the predictive power of their model.

A model that cannot predict a global financial crisis seems horribly flawed to me. That is why I proposed N Theory and crafted the rules of the theory to predict major financial disruptions. N Theory unlike the other theories identifies the major flaw (bank runs) in our current economic structure and alerts us to the fact it is an unresolved issue likely to re-offend. I am delighted Jean-Claude Trichet sees a need for new theories like N Theory.