Sebastian Poledna & Elena Rovenskaya from the OECD’s Strategic Partnership with the International Institute for Applied Systems Analysis (IIASA) present work on forecasting financial crises using a large-scale ABM model.
The financial crisis of 2007-2008 and the subsequent Great Recession sparked widespread discussion among economists on the requirements for future macroeconomic models. The benchmark model in 2008 of Smets and Wouters, which shares many features with models currently used by central banks and large international institutions, did not give any warning of the emergence of a crisis in 2008 and has difficulty explaining both the depth and the slow recovery of the Great Recession. To address these and other shortcomings, we develop an agent-based model for the euro area that fulfills widely recommended requirements for future macroeconomic models by i) incorporating financial frictions, ii) relaxing the requirement of rational expectations, iii) including heterogeneous agents, and iv) building on appropriate micro-foundations.
Using macroeconomic and sectoral data, the model includes all sectors (financial, non-financial, household, and a general government) and integrates the real side and financial flows as well as balance sheets with stock-flow consistency. Moreover, the model incorporates many features considered important for future policy models, such as a financial accelerator with debt-financed investment, a complete GDP identity, and allows for non-linear responses.
Importantly, we show that the agent-based model can compete with dynamic stochastic general equilibrium and vector autoregression models in out-of-sample prediction. We demonstrate the model during the Financial crisis of 2007-2008 and the subsequent Great Recession as well as the European sovereign debt crisis—two crises that dynamic stochastic general equilibrium models struggled to predict and have difficulties explaining. Making use of out-of-sample forecasting exercises we show that the model predicts an endogenous crisis around the most intense phase of the Great Recession in the euro area, albeit with lower severity without a global downturn (which is exogenous to the model). With conditional forecasts, which include an exogenous shock on exports from the global downturn, we demonstrate that the model explains both the severity and slow recovery of the Great Recession.
This will work was presented during the NAEC Integrative Economics Conference on 5-6 March, but the LAB Discussion focused on the details of the modelling approach.