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05. Reduce uncertainty on the possible impacts of policies


When policy options have been developed, simulations are carried out to anticipate the likely impact of policies. The option with the most positive impact is normally the one that is proposed for adoption.

Most existing methodologies and tools for the simulation of policy impacts work decently with well known, linear phenomena. However, they are not effective in times of crisis and fast change, which unfortunately turn out to be exactly the situations where government intervention is most needed.

As an example nowadays the European Central Bank bases its analysis of the EURO Area economy and monetary policy on a derived version of the DSGE model developed by Frank Smet and Raf Wouters in 20036. Smet and Wouters’ model is deeply microfounded, allowing for a rigorous theoretical structure of the model. Moreover in this setting the reduced form parameters are related to deep structural parameters in order to mitigate Lucas’ critique, while the utility of agents can be taken as a measure of welfare in the economics (Phelps ed. 1970).

However, the DSGE models suffer from several shortcomings jeopardizing their ability to predict, let alone to prevent, a global crisis:
  1. Agents are assumed to be perfectly rational, having perfect access to information and adapting instantly to new situations in order to maximize their long-run personal advantage
  2. So far agents have entered the models as homogeneous representative entities, while it would be a step forward being able to take into account agents heterogeneity
  3. Canonical models consider atomistic agents with little or no interactions and thereby are not able to cope with network externalities
But most of all it is the very notion of equilibrium which prevents standard models from dealing with crisis. A stable steady state equilibrium is a condition according to which the behaviour of a dynamical system does not change over time or in which a change in one direction is a mere temporary deviation. This condition is proper of general equilibrium theory, in which a stable steady state is believed to be the norm rather than the exception. When in the canonical model we are out of equilibrium, the situation is seen just as a short lapse before the return to the steady state. This is in sharp contrast with the very notion of crisis, which represents a steady deviation from the equilibrium. Loosely speaking, the crisis phenomenon is not even conceived within the framework of standard models.

All these flaws are not only related to DSGE models, Computational General Equilibrium (CGE) or macro-econometric forecasting models, but generally affect the traditional policy making tools. In this view it would be very important to find new frameworks capable of avoiding those shortcuts. Some of such methodologies and methods already exists, e.g. System Dynamics and other hybrid models, and some governments are using them. Our aim is to push forward in that direction.

We need to move away from the equilibrium paradigm in order to be able to assess other issues: evolutionary dynamics; heterogeneity of technologies and firm; political and legal determinants of social stability; incentive structures; better modelling technological change, innovation diffusion and economic systems (taking into account finance, debt and insurance); interactions between heterogeneous economic agents (firms and households) and central governments; heterogeneous responses to government incentives; economic dependence from the ecosystem.

Trichet, the former head of ECB, clearly put it: “This doesn't mean we have to abandon DSGE...(but)...atomistic rational agents don't capture behaviour during a crisis...rational expectations theory has brought macroeconomics a long way ... but there is a clear case to re-examine the assumptions”

But the need for new policy making tools is not limited to the economic realm: in the future it will become more and more important to anticipate non-linear potentially catastrophic impacts from phenomena such as: climate change (draught and global warming); threshold climate effects such as poles’ sea-ice withdraw, out-gassing from melting permafrost, Indian monsoon, oceans acidification; social instability affecting economic well being (social conflict, anarchy and mass people movements).

Lack of understanding of systemic impact has driven to short term policies which failed in grasping long term, systemic consequences and side effects:

  1. An example of this approach might be given by the sovereign debt issue. In fact it is relatively easy for governments under popular pressure to increase expenditure and public debt to cope with short term necessities, such as offsetting the negative impacts brought about by a regional or global crisis. On the other hand it is harder to take into account the long term effect determined by higher interest rates on private investments and consumption through crowding out and fiscal pressure
  2. Another example of short-termism are the financial policies pursued in south East Asia at the beginning of the 90s. Many countries, such as Thailand, liberalized their financial markets fostering the inflow of investments aimed at sustaining growth. Unfortunately those capitals triggered a real estate bubble which has been at the roots of the 1997-1998 crisis
  3. In 2008 the Central Bank of Iceland yielded liquidity loans for saving banks on the verge of default on the basis of newly-issued, uncovered bonds, i.e. effectively printing fiat money on demand, causing a significant rise in inflation. To cope with this rise in prices, the Iceland Central Bank had to keep very high interest rates thereby leading to an economic bubble
  4. According to a great number of economists the financial crisis was triggered by US government policies spanning across two administrations which were intended to ensure citizens’ right but instead determined an unprecedented high number of risky mortgages, as well as the decline in mortgage underwriting standards that ensued. According to the “Financial Crisis Inquiry Commission Report” 7 those policies, together with the deregulation of the financial system, might have been catalyzed the crisis.
  5. Other examples can be the bail out of financial institutions: in the short run those actions maintain employment and economic standards, while in the long term they induce moral hazard, keep operating inefficient companies and decrease the trust of economic agents in regulation, which is the funding pillar of our economic system
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Key challenges for policy-makers
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05. Reduce uncertainty on the possible impacts of policies
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01. Emergence of a distributed governance model
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02. Detect and solve problems before they become unsolvable
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03. Generate high involvement of citizens in policy-making
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04. Identify “good ideas” and innovative solutions
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06. Ensure long-term thinking
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07. Encourage behavioural change and uptake
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08.Manage crisis and the “unknown unknown"
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09. Moving from conversations to action
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10. Detect non-compliance & mis-spending through better transparency
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11. Understand the impact of policies
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