Assessing the major changes in Economics for the 21st century and its effects on Finance, Capital and the treatment of Economics
A brief look at Europe today (and prior to the EMU), shows asymmetries between countries, deep unemployment and the emergence of a young group now called the lost generation who face an uncertain future. Some may argue that the euro was purely a political agenda rather than an economic one, however, one cannot argue about the analysis which overall provided a ‘thumbs up’, having failed to assess many pressing economic, ‘what if’ scenarios.
Economics seemed to be a by-product during the EMU debate. A pressingly and much deeper understanding of the asymmetries, the different banking structures and their associated risks, together with a full assessment/evaluation and understanding of the outcomes of economic shocks and their adjustment processes within these countries was needed. The EMU is only one example for the need to treat Economics as a serious subject, different to much of the previous and current analysis based on economic cycles and gut-feelings. Economics should be a subject that encompasses sophisticated analysis and robust methodology and thinking far beyond what is already known, and a subject which allows for the development of new ideas ready to tackle challenges of the 21st century.
Consequently, following the financial crisis, the Institute for New Economic Thinking (INET) emerged. This is an independent non-profit organisation geared towards developing and testing new ideas in Economics. Within this structure is the Young Scholars Initiative, a new generation of thinkers working alongside professors in the creation, development and testing new initiatives in Economics. This article highlights just a few of the examples of how Economics is developing and their impact on finance and capital. For example, researchers have strongly examined the euro banking system and concluded that there is a limit to the absorption properties of countries at the national level. For a future banking union, this tension must be dealt with by a national ‘firm loss’ limit, allowing the European Sustainability Mechanism to undertake direct capital injections into the national banking system when national recapitalisation costs exceed that limit, changing the way capital is used.
The future of Economics encompasses new methodologies and metrics which will revolutionise both the teaching and implementation of the calculation, analysis and reporting affecting capital and finance globally. Before looking at new Economics, we must understand its history. If economists are to have any knowledge of the future, they must have knowledge of the past. INET has introduced Economic History as a starting point which precipitates a requirement for practitioners to understand how historical events have effected policy decisions, providing an insight into the real world today, and by empirically evaluating its history, they can further delve in to the more complex theoretical components of Economics. For example, areas within INET (using bibliometrics) examine securities in the 18th century and assess securitisation on the financial and real markets and the distortion effect. With better understanding of these concepts, fund managers today can assess their portfolios and their linkages in the real world, thus making better decisions with lower risks and learn that mass capital flows and greater liquidity does not necessarily translate to profits.
Recently, economic models, called now-casting models, have materialised which provide forecasts in real time or, forecasts for the present and the very near future. A great deal of academic research has culminated in the production of models which update information as it happens, (rather than merely using retrospective data) and this information can be in the form of ‘soft’ or ‘hard’ data. As mass data flows flood the economy, the task is to incorporate all this information using models which accept the challenge of timeliness and noisiness. These sophisticated models sift through all the information and identify the appropriate data and relationships to produce accurate, policy relevant forecasting outcomes.
A new technique can also be used which forecasts the outcomes of economic shocks using real time data, establishing the shock’s magnitude, duration and adjustment process (a invention of the author), allowing users of this information to practice ‘what if’ scenarios. These methods also require the use of Economics as an accounting system. That is, economists must recognise that economies are a system of detailed entries containing full information of the financial sector which includes all off–balance-sheet assets and debts. Financial accounting standards must be strictly incorporated into Economics if we are to predict essential information. If economic models previously included a strict series of national accounting within economic systems, would the economic landscape in 2008 have been the same?
A very important and popular topical issue is Financial Contagion which refers to the likelihood that significant economic changes in one country will spread to other countries. Contagion can refer to the spread of either economic booms or economic crises throughout a geographic region particularly as countries become more correlated - the 2008 banking crisis being an example. New Economic thinking proposes to better understand the nature of banking systems and systemic risk which in-turn will lead to improved ‘capital flow management’, improved coordination of capital accounts and strengthening of policy framework and this ‘capital flow management’ framework may include a package of available policy options including macroeconomic policies, prudential measures and new forms of capital controls.
There have been renewed calls for new development in the measure of systemic risk. In financial terms, systemic risk refers to the collapse for the entire banking system. Therefore, developing sophisticated economic models to examine the relationship between the financial systems and the real economy has become a critical. A greater understanding of the inter-linkages is required if global economies are to avoid repetitions of previous crises. The Economics profession had previously been accused of ‘herding’ behaviour, discouraging economic modelling diversification. Investment managers have been accused of similar practices in terms of their investment decisions. With fully explained new methodology in social-institutional processes, financial practices will change with less correlated ‘herding’ practices across different classes will occur leading to less fragility in the financial system. This is achieved by changing the incentives that institutional investors face which affects decision making and the disastrous effects of ‘herding’.
Human Capital and Economic Opportunity highlights the failure of various markets to properly quantify the price of the economic value of human capital both nationally and globally. Since these values have not been accurately calculated, this has give rise to discrepancies in economic development, declining growth, increasing economic inequality. New research has provided a base for understanding the relationship between human capital development at the micro level and macro levels. The focus of learning is enriched by considering family and community influences and not just credit markets. Developing research gives a comprehensive understanding of the determinants of human flourishing, of which human capital is an essential component. One of the benefits of this study is the ‘Pay for Success’ programme whereby leaders harvest working capital and are able to invest financial capital to support early education initiatives, seen essential to development and progression and the leap towards economic success.
Simple economic models cannot capture the complex processes that make up Economics. Complexity Economics (CE) is an emerging area with the aim of creating new methodologies into complex areas where models account for network effects, interconnectedness, positive and negative feedback amongst many other effects. The areas of innovation and research include: (i) Financial system stability; (ii) studies into economic growth and innovation and; (iii) risk and resilience. Many of the research issues here surround the necessity to understanding economic policy by exploring agent based modelling. CE dismisses the ideas that the financial markets are efficient and the price of an asset reflects its efficiency together with the notion that the more liquid the market, the better functioning it becomes.
Like many of the earlier mentioned new initiatives, CE formulates new ideologies in that markets with lower liquidity levels create incentives for investment opportunity and a better placement of capital. Often, with excessive liquidity, the upshot may be boom and bust cycles. Further to new thinking, currently, the financial system lacks decoupling strategies (e.g. reliable “breaking points”), which allowing the separation of affected parts from the rest with a separation of banks into business banks and investment banks. This should improve the allocation of capital and risks in the financial system.
New Economic thinking encourages the innovation of ideas for testing and implementation and there are numerous topics, for example Imperfect Knowledge Economics (a popular topic) which looks at new models to analyse rational human behaviour, thus better explaining how markets behave and asses how policymakers must cope with inherently imperfect knowledge. New Economics is developing for the 21st century and the idea is to innovate, educate and implement and in doing so, we can bridge the gap between the academic and business world.
Dr. Victor Chukwuemeka
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