The OECD launched the New Approaches to Economic Challenges (NAEC) initiative in the wake of the 2008 financial crisis to understand the shortcomings of the analytical frameworks we had relied on and to establish the basis for a better way to produce policy advice. The obvious place to start was with economic models, but the problem was deeper than poor parameters and incomplete data. The models did not reflect the reality of the economy or of people’s lives in that economy; and they did not anticipate how the pain of the recession would lead to social and political crises.

Why did so many highly competent people, using highly sophisticated techniques, not see the crisis that was coming? Why were we so comfortable with the results of our models, and the underlying assumptions? To put it simply, our analysis and understanding of financial markets and their impact on the real economy were not helpful in presenting the real level of risks we were confronting. In fact, the role of the financial system in traditional macroeconomic approaches rarely went beyond determining yield curves and stock prices.

In September 2018, NAEC convened experts on the financial system, including some who had played a role at the heart of the crisis, to discuss what we had learned from the experience of 2008. The group was diverse and the debate was lively, but there were repeated calls for macroeconomists to emphasise the complexities of the financial system in their models, rather than relying upon traditional methodological assumptions and modelling approaches. Adair Turner, Head of the UK Financial Services Authority (who writes on monetary finance in chapter 28), has gone so far as to say that “bad or rather over-simplistic and overconfident economics helped create the crisis”.

The crisis and its aftermath exposed major flaws in the formation and assumptions of the standard macro-economic models – particularly concerns of computational irreducibility, emergence, non-ergodicity, and radical uncertainty, or Rick Bookstaber’s (Chapter 5) “Four Horsemen of the Econopalypse”. Jean-Claude Trichet (Chapter 15), found the traditional tools at his disposal of little use to address the serious economic policy challenges facing his institution in the midst of economic and financial meltdown.

Andy Haldane, Chief Economist of the Bank of England (Chapter 2) calls for the use of complexity theory to understand the overall architecture of public policy – how the various pieces of the policy jigsaw fit together as a whole in relation to the economic and financial systems. These systems can be characterised as a complex, adaptive “system of systems”, whose architecture means that policies with varying degrees of magnification are necessary to understand and to moderate fluctuations. It also means that taking account of interactions between these layers is important when gauging risk. Bill White discusses some simple implications of complexity for policymakers (Chapter 11).

Unfortunately, financial interconnectedness, one of the apparent strengths of the global economy, makes risk assessment far more difficult to reliably execute than previously. Before 2008, market interconnectedness increased with the aid of policies encouraging the liberalisation of capital flows and the deregulation of derivative markets. After 2008, however, interconnectedness has been associated with the risk of financial contagion, where a toxic or failing financial institution impacts upon all others directly or indirectly. In mainstream economic science, such complexity and financial instability remains difficult to understand theoretically, let alone model quantitatively and inform international economic policy.

Fundamentally, we have limited ability to predict the threats which exploit financial and economic vulnerabilities and generate international economic recessions. We have limited capability to predict which economic threats may arise, how they will impact our financial and economic systems, or how to identify the correct steps needed to mitigate disruption or prevent it from occurring. However, there are indicators of potential sources of vulnerability, such as public and private debt. Governments, non-financial corporations, and households collectively owe USD 72 trillion more than they did in early 2008, and debt to GDP ratios have risen for many countries. Another indicator comes from financial market innovation, with high-speed algorithms trading the USD 3 trillion of passive exchange-traded products created since the crisis. Yet another source of vulnerability is the shadow-banking sector.

One of the most striking interventions at the 2018 NAEC conference came from John Llewellyn (Chapter 22), Chief Global Economist of Lehman Brothers in 2008. When asked if he saw any parallels between then and now, he replied that in both cases, experts, even within the major banks, were sounding warnings that decision-makers ignored. In the mid-2000s, those warnings focused upon the systemic fragility and growing weaknesses of the financial system due to the over-investment in highly risky and volatile assets. Today, Covid-19 has shown that there are multiple potential global systemic crises, each of which could disrupt many facets of daily life. Martin Wolf (Chapter 32), Michael Jacobs (Chapter 31) and Anat Admati (Chapter 30) highlight some of the dangers ahead with regard to financial leverage and debt. Mathilde Mesnard and Robert Patalano (Chapter 33) discuss new vulnerabilities.

What can policymakers do about this grim reality?

First, accept that new crises will occur and they will not be limited to one domain – a health emergency can quickly become a financial and economic crisis, as happened with Covid-19. Whatever their initial label, all crises have similar features that should be considered when designing policy approaches to recovery and adaptation in the aftermath of a systemic upheaval. The tensions already exist, and the cascading impacts of a crisis that spreads from one domain to others will impose significant strains on most socio-political systems, and, as we have seen, force governments to make difficult choices.

Second, policymakers will need new tools to understand complexity and to manage rising levels of risk under conditions of uncertainty in an interconnected, non-linear, systemic world. Economic systems should be modelled and managed as complex adaptive systems (See Andrew Lo in Chapter 4 on adaptive markets).

Finally, we need to shift from risk-based to resilience-based approaches to model and govern the financial system and other systems. Resilience-based approaches cannot predict the cause of the next global recession, but they can limit the scope of any potential contagion, and improve the pace and scale of economic recovery. Resilience approaches focus on the ability of a system to absorb, recover from, and adapt to a wide array of shocks to help individuals, communities, and larger groupings not just deal with adversity, but adapt in a positive way to change and take advantage of the opportunities it offers. While the financial regulatory and supervisory framework has been substantially strengthened since 2008, there is still scope to integrate resilience more effectively in our policies and monitoring tools.


Juan Yermo

Chief of Staff, OECD

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