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When Money Takes Strange Paths – The Imperfection of Financial Markets as an Object of Academic Curiosity

When money takes strange paths – Potsdam economists are examining how imperfections in financial markets influence cash flow between developing countries and industrial nations. Photo: Fotolia/eyetronic
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When money takes strange paths – Potsdam economists are examining how imperfections in financial markets influence cash flow between developing countries and industrial nations. Photo: Fotolia/eyetronic

Potsdam economists are examining how imperfections in financial markets influence – in the case of a general liberalization –cash flow between developing countries and industrial nations. The researchers are preparing theoretical models that aim to realistically map and explain their observations.

The financial crisis has not only shaken the global economy but also caused quite a stir in the academic world. It showed just how strongly financial market happenings can influence overall economic performance – a fact that has often been neglected by economists in Germany. This is expected to change. A “Priority Program” funded by the German Research Association (DFG) focuses on “imperfections” in financial markets and their impact on macroeconomic development.

“We are trying to integrate imperfections into our models,” says Maik Heinemann, Professor of Economic Growth, Integration and Sustainable Development at the University of Potsdam. He and his research assistant Alexander Wulff are working on the subproject “International Integration in Heterogeneous Agent Economies with Capital Market Imperfections”.

Reality is never perfect, the layperson marvels. The expert laughs and says, “You are right,” least of all trading in debts, securities, and currencies. One possible imperfection is called “asymmetric information” in the economist jargon, in which various economic actors in financial markets have varying levels of knowledge. Another imperfection is called a “moral hazard”: As a result of their insurance or loans, the insured or debtors are tempted to act carelessly and to the detriment of the institutions. In the 1970s, when the financial sector started to grow, models considering such imperfections did begin to be developed, Heinemann says. Economists, however, assumed that these phenomena were not able to cause a lasting disruption of the overall system and were irrelevant to many issues.

But how can you represent a complex reality full of imponderability? By simplifying. “We do it like physicists do with ideal gas,” Heinemann says. To be able to describe how a gaseous substance behaves under heat or changing pressure, physicists neglect the volume of the individual atoms or molecules as well as the forces between them. This gives them a lean formula that describes the behavior of a real gas quite well.

Economists have adopted this method. Financial friction is irrelevant to an equilibrium model for ideal financial markets, and individual risk can be completely insured. Such an idealized representation sufficed as long as the economy was functioning somewhat normally. What was happening in the financial markets could be easily ignored because it hardly influenced the overall result. This has changed since the crisis: “We now know that some financial products harbor systemic risk.”

The economists, therefore, increasingly fall back on models with “heterogeneous” economic subjects in order to analyze the effects of financial markets’ imperfections. These models proceed from the assumption that differences emerge slowly even if all actors have an identical baseline. Setbacks and external influences can limit the options. In addition, individual actors handle restrictions and the distribution of risk differently.  Heinemann’s and Wulff’s particular project deals with the question of what would happen if such heterogeneous national economies opened up and integrated into the international capital and commodities markets, but, at the same time, financial markets offer no full risk hedge and allocation, i.e. the distribution of productive capital does not function optimally. “We are primarily interested in the less developed countries where such friction plays a considerable role,” Heinemann explains. People in these countries cannot count on a steady and secure income and hardly anyone can insure against these and other risks.

Classical economic theory predicts that capital should flow from richer countries to open economies of poorer countries because labor is cheaper, enabling a high return on investment. In reality, though, this does not happen. On the contrary, capital flows from poor countries to rich industrialized ones. This phenomenon is called Lucas Paradox, named after Robert Lucas who received the Nobel Prize in Economics in 1995.

“We are trying to find out if and to what extent imperfections in financial markets can explain this paradox,” Heinemann says. For this, the researchers have to deviate from the idealized model: Risk and opportunity in a perfectly functioning financial market would be evenly distributed because the corresponding information is available to all market actors. There would be no conditions or restrictions for granting loans because the default risk would be ensured. These utopic conditions do not even exist in industrialized countries. The financial markets of less developed economies are full of imperfections.

Existing models suitable for representing these processes refer to closed national economies. The economists at the University of Potsdam have modified these models to be able to apply them to countries that are liberalizing their markets and are on the verge of development. These modifications refer especially to restrictions in the credit system and other factors. When legal regulation and public institutions are weak, companies seeking to expand receive only limited loans because banks can only insufficiently insure against delayed or no repayment. This means that capital cannot always be used where it is the most productive. As a result, excess supply lowers the return on national budgetary savings. If there is an exchange between countries with well-developed financial markets, the capital follows the higher interest rates abroad. As a consequence, it flows from poor to rich. The welfare effects for the individual can differ greatly. National budgets with high capital assets reap the benefits while debtors tend to suffer higher capital costs.

Drawing up such complex models cannot be done by pencil and paper. Expensive computer simulations are necessary to calculate and describe the individual mechanisms, especially the various welfare effects. “It is vital to get an in-depth understanding of the consequences of a certain assumption in the model,” Heinemann explains. “This is the only way we can systematically analyze the empirical results in later steps.”

The Project

The central purpose of the DFG Priority Program 1578 “Financial Market Imperfections and Macroeconomic Performance” is to advance research at the intersection of macroeconomics and financial economics. This has received too little attention in Germany, according to the research application. Researchers from different universities are examining incomplete markets, asset price bubbles, and monetary policy in individual projects. The program coordinator is Prof. Tom Krebs from the University of Mannheim. Researchers from Potsdam are collaborating with their colleagues in Bielefeld on the project “International Integration in Heterogeneous Agent Economies with Capital Market Imperfections”. The program began in 2010 and is to be completed by 2015.

The Researcher

Prof. Maik Heinemann received his habilitation in economics at the University of Hannover. He taught and researched in Frankfurt/Main, Göttingen, and Lüneburg before becoming Professor of Economic Growth, Integration and Sustainable Development at the University of Potsdam in 2011.


Universität Potsdam 
Wirtschafts- und Sozialwissenschaftliche Fakultät 
August-Bebel-Str. 89 
14482 Potsdam
E-Mail: maik.heinemannuni-potsdamde

Text: Sabine Sütterlin 
Translation: Susanne Voigt
Online-Editing: Silvana Seppä
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