'No one saw this coming' – or did they?

Dirk Bezemer, 30 September 2009



From the very beginning of the credit crisis and the ensuing recession, it has become conventional wisdom that "no one saw this coming". Anatole Kaletsky (2008) wrote in the The Times of “those who failed to foresee the gravity of this crisis - a group that includes Mr King, Mr Brown, Alistair Darling, Alan Greenspan and almost every leading economist and financier in the world.” Glenn Stevens (2008), Governor of the Reserve Bank of Australia, said:

“I do not know anyone who predicted this course of events. This should give us cause to reflect on how hard a job it is to make genuinely useful forecasts. What we have seen is truly a ‘tail’ outcome – the kind of outcome that the routine forecasting process never predicts. But it has occurred, it has implications, and so we must reflect on it”.

We must indeed.

What now for economic modelling?

One result from such reflection would be that in fact, many had predicted this course of events for years. In a recent study (Bezemer 2009), I document the economists who did “see it coming”. At least a dozen serious analysts issued fairly detailed, well reasoned, and public warnings of imminent finance-induced recession.

They were apparently ignored by Stevens and other central bankers who then, as Alan Greenspan professed in his October 2008 testimony, watched with “shocked disbelief” as their “whole intellectual edifice collapse in the summer [of 2007]”. The official models they relied on missed the crisis not because the conditions were so unusual, as we are often told. They missed it by design.

It is impossible to warn against a debt deflation recession in a model world where debt does not exist. This is the world in which our policymakers have been living, and they urgently need to change habitat. The question that the economics profession now needs to address is – whereto? If our routine forecasting models – CGE models, mostly – failed to foresee this, where do we look for alternatives?

The types of models that got it right

In Bezemer (2009), I document the models that got it right. The important question for economists is – how did they do it? What is the underlying model?

While there is obviously a diversity of approaches, one important strand of thinking is an accounting of financial stocks (debt and wealth) and flows (of credit, interest, profit and wages), as well as explicit analysis of both the real economy and the financial sector (including property).

The most detailed of these models, which has also been used to construct public projections and analyses, are “Flow of Funds” models of the US developed by Wynne Godley and associates at the Levy Economics Institute. These may serve as pars pro toto for the class of “Flow of Funds” models of real-financial interactions (e.g. also Werner, 1997; Graziani, 2003; Hudson, 2006; Keen, 2009). A simplified (closed-economy) representation in Godley (1999) consists of stocks and flows of a number of asset classes between four sectors (explicitly separating out the financial sector), with their properties and interrelations represented in over 60 equations (Table 1; see Godley 1999 for all symbols).

Table 1. The flow of funds in matrix representation

Source: Godley (1999:395)

Flow of funds models

In “Flow of Funds” models, liquidity generated in the financial sector flows to firms, households and the government as they borrow. This may facilitate fixed-capital investment and production, but it may also feed asset price inflation, consumption, and debt growth. Liquidity returns to the financial sector as financial investments or in payment of debt service and financial fees. Key features of “Flow of Funds” models are thus bank credit flows, since “evolving finance in the form of bank loans is required if production is to be financed …” (Godley, 1999:405). Also, there are explicit payment flows such as interest, “not quite the same as in the national accounts, where it is standard practice… to ignore interest payments, although they are an inevitable cost given that production takes time” (Godley, 1999:405).

The model is solved by imposing macro accounting identities and adaptive expectations rather than individual optimisation. There is a steady state but not equilibrium. One advantage is that growth paths can be identified as unsustainable given the existing “bedrock” accounting relations. This allowed Godley and Wray in 2000 to conclude that “Goldilocks was doomed” – with a government surplus and current account deficit, US economic growth had to be predicated on ongoing and unsustainably high rates of private debt growth.

What’s missing from the mainstream models?

This inference is impossible to make from national or OECD forecasters’ models, where balance sheet variables or interest flows are conspicuous by their absence. These CGE models do not include a separate financial sector, ruling out finance-induced recession by design. Money supply and interest rate variables are included in those models, but they are fully determined by real-sector variables such as the output gap. Also, the process of money stock growth or asset market inflation – by bank lending which increases debt levels and elicits return flows of interest – are not modelled. This fits in with a “reflective finance” view; the financial sector, rather than developing its own dynamic, is assumed to adapt to the “real fundamentals”, so that explicitly modelling it is superfluous.

The contrast with actually existing finance-induced recessions should lead forecasters to reconsider their models. Interestingly, there have been moves in recent years towards including balance sheets and the flow of funds in official models. Rae and Turner (2001) write that introducing “alternative assumptions allows a little more economic richness to be temporarily added to the [OECD Small Global Forecasting] model when it is used for policy analyses, especially for those situations in which financial markets and expectations play important roles in the transmission of shocks within and between regions”. In addition to its ad hoc adjustment to the reality of balance sheet effects, the OECD appears to be working on a new “Interlink” model, triggered by “changing conditions” and including “domestic and global stock-flow consistency with respect to wealth linkages and wealth effects” (Richardson 2006), very similar in name at least to Godley’s “stock-flow consistent model” (Godley and Lavoie 2006).

So far, however, monetary (and other) policymakers have resisted inclusion of balance sheets and the flow of funds in their models and policy responses. Greenspan famously preferred to “mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion”. But the underestimation of the severity of the fallout (global recession) throws the desirability of the transition to the next expansion into doubt if it is to be driven by debt accumulation. Also, the argument that bubbles cannot be timely identified nor their effects reliably anticipated is rebutted by the analysts reviewed in my paper who did both.


While the jury is still out on the question whether CGE models and “Flow of Funds” models can be married, exploring these avenues is now urgent. Benjamin Friedman recently noted that, “what is sorely missing in the discussion is attention to what function the financial system is supposed to perform in the economy and how well it has been doing it”. “Flow of Funds” models provide just that. If the crisis and recession teach us one thing, it is that the financial sector is just as real as the “real economy”. We economists – and the policymakers who rely on us – ignore balance sheets and the flow of funds at our peril.

Editor’s note: The author’s short Comment on this topic was published by the Financial Times on 8 September 2009.


Bezemer, Dirk J (2009), “No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models. Unpublished.
CPB (2009), “Central Economic Plan 2009” (in Dutch). The Hague: Centraal Planbureau.
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Godley, W (1999), “Money and Credit in a Keynesian Model of Income Determination”, Cambridge Journal of Economics 23(4): pp. 393-411.
Godley, W and M Lavoie (2006), Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth. Houndmills, Basingstoke, Hampshire UK Palgrave-Macmillan.
Godley, W and R Wray (2000), “Is Goldilocks Doomed?”, Journal of Economic Issues 34: 201-206.
Graziani, A (2003), The Monetary Theory Of Production. Federico Caffe Lectures. Cambridge; New York and Melbourne: Cambridge University Press.
Greenspan, A (2008), “Testimony for the Committee of Government Oversight and Reform”, 23 October.
Hudson, M. (2006), “Saving, Asset-Price Inflation, and Debt-Induced Deflation”, in L. Randall Wray and Matthew Forstater, eds., Money, Financial Instability and Stabilization Policy Edward Elgar, 2006:104-24.
Kaletsky, A (2008), “It’s An Emergency. Long-Term Cures Must Wait”, The Times, 13 November.
Keen, S (2009), “The Dynamics Of The Monetary Circuit”, in Jean-François Ponsot and Sergio Rossi (eds.), The Political Economy of Monetary Circuits: Tradition and Change. Houndmills, Basingstoke, Hampshire UK: Palgrave, London
Rae, D and D Turner (2001), “A Small Global Forecasting Model”, Working Paper 286, OECD Economics Department.
Reuters (2007) “US Recession Risk Still Below 50 Pct”. 5 September.
Richardson, P (2006) “The Structure And Simulation Properties Of OECD’s Interlink Model”.
Stevens, G. (2008), Speech to the Australian Business Economists, December 9. 
Werner, R (1997), “Towards a New Monetary Paradigm: A Quantity Theorem of Disaggregated Credit, with Evidence from Japan”. Kredit und Kapital, 30,2. Berlin: Duncker & Humblot., 276-309.

Topics: Global crisis, Macroeconomic policy
Tags: Central Banks, flow of funds, global crisis


BIS economist William White

BIS chief economist William White warned all of the leading central bankers of the coming bust and he did it at a conference with all of the major central bankers in attendance.

The central bankers have no excuses.

Assistant Professor in the Department of International Economics and Business, University of Groningen