WHY ECONOMIC MODELS DON’T HAVE MUCH TO SAY ABOUT FINANCIAL CRISES.

WHY ECONOMIC MODELS DON’T HAVE MUCH TO SAY ABOUT FINANCIAL CRISES. Professor Summers pointed out that: “the academic mainstream of mathematical models festooned with Greek symbols and complex abstract relationships” doesn’t have much to say about financial crises. One reason is that financial crises don’t lend themselves well to modeling. Take the first two of the three lessons that Professors DeLong and Eichengreen take from Kindleberger. The first is that “panic is intrinsic in the operation of financial markets.” Panic is hard to predict and hard to model. A panic is a black swan. The second lesson is the “power of contagion”. The financial and psychological links and channels that spread panics are hard to model because hard to predict. The crisis after the Lehman failure illustrates both points. The extent of unknowable counterparty risk had not been taken into consideration, but it is hard to see how a mathematical model could do much in explaining how events in i931 “in a relatively minor European financial centre, Vienna”, could quickly spread through financial and psychological channels to trigger a financial catastrophe.