Fed chairman Ben Bernanke has said the Fed underestimated the size of the Great Recession because it neglected that the housing bust was concentrated on a very leveraged financial sector, unlike the dot com bust which had a wider fallout.
In his latest piece in Bloomberg View, Peter Orszag says the problem with the macroeconomic models used by the Fed, the Congressional Budget Office, and the White House, is that they have a "very rudimentary financial sector built into them."
Instead he points to models like those crafted by economists Simon Gilchrist and Egon Zakrajsek which have built on a traditional macroeconomic model with a measure of financial industry stress - namely - credit spreads on bonds issued by financial institutions. From Orszag:
"This model, the authors conclude, “can account for the broad movements in consumption, investment, hours worked and output observed during this period.” And since 2007, some progress has been made in incorporating metrics of financial stress into macroeconometric models. But the progress remains inadequate.
So here’s a rough rule of thumb: Whenever a reasonable financial-stress index, such as that produced by Gilchrist and Zakrajsek, is particularly elevated, be very skeptical of economic forecasts from models that pay scant attention to the financial industry. They will be making the housing- meltdown-is-just-like-the-tech-one mistake all over again."
Read the entire piece at Bloomberg View >
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