The Evolutionary Paths Toward the Financial Abyss and the Endogenous Spread of Financial Shocks into the Real Economy

The current global crisis has not only demonstrated the incontestable importance of banking and financial markets for the dynamics of real economies, it has also become a “natural experiment” for economic analysis, revealing the total inadequacy of the dominant theoretical framework. The basic assumptions of mainstream DSGE models (e.g., optimizing behavior, equilibrium, rational expectations, “representative agent,” etc.) are to a large extent responsible not for the failure to forecast the timing of the onset of the crisis, which would have been pardonable, but for constructing models in which such crises could simply not happen. These models assumed that only exogenous shocks can move the economy from that path and that the economy is “stable,” i.e., that it will return naturally to that path. This project investigates and formalizes the generic drivers of financial market dynamics underlying boom-and-burst dynamics and empirically explores the transmission mechanisms from financial to real dynamics.