After the recent two weeks of tumult in the American economy, consumers couldn't be blamed for wishing they had a crystal ball that could help them see into the uncertain future. Will there be a recession? How bad would it be? Should Congress and the White House launch a $700 billion Wall Street rescue mission?
The closest alternative to a crystal ball, in the real world, is a computer model of the economy. Back in the 1980s, one such model was created by none other than Ben Bernanke, who's now at the center of the crisis as the chairman of the Federal Reserve.
Bernanke's computer model is called the "financial accelerator." It's now in the office of Mark Gertler, an economics professor at New York University, who worked on it with Bernanke decades ago. You might expect a model of the economy to look like a video game, with avatars and a virtual trading floor. But when asked to show off the financial accelerator, Gertler turns to his computer and starts printing out paper.
That's because he and Bernanke worked on equations, not computer programs. "For that, we have highly intelligent and ambitious graduate students," Gertler says.
The research paper he prints out is filled with what look like physics equations. Does the model include people or stock brokerages? "Absolutely," he says. "The firms issue equity and debt."
Economists generate lots of models of the economy, simulations that consider various aspects of the financial system. The one created by Bernanke and Gertler stands apart, because it was designed to incorporate the ripple effects of shocks to the financial market.
In other words, the model considers exactly what's happening now, as financial institutions fold or run for shelter in larger firms. Modeling is necessarily an unexact science. "Ultimately, we would like to make precise predictions," Gertler says. "Yes, we know the economy will get into trouble, or can get into trouble under these forces. But we'd like to say how much."
Does the model say the economy is heading for doomsday, unless there's an intervention? Gertler pauses, then says, "Uh, roughly speaking, yes."
The Mathematics Of Disaster
Bernanke and Gertler's model calculates the ways a particular blow to the system could snowball dangerously.
In a credit crisis like the current one, for example, it's hard to borrow money. To take out a loan, consumers have to pay interest that's higher than usual. The result is that people and companies have less money, so they spend less. The economy slows.
In a cooling economy, the value of houses and companies can decline. That makes it yet harder to borrow money, because their collateral is worth less. Fueling itself, the whole cycle moves faster and faster.
"We called it 'accelerator' because it's accelerating the downturn," Gertler says.
A Window Into Bernanke's Mind
Economists, including Gertler and Bernanke, know that any given model is likely to stray far from the target. Gertler says their model did a good job of explaining what happened during Southeast Asia's financial crisis in the late 1990s. South Korea's gross domestic product dropped 12 percent. More than half of that, the model said, was due to the "financial accelerator" effect.
Gertler thinks the logic behind the model is affecting Bernanke's thinking during this crisis. He says they've talked the matter over. "One thing I can let on is he said, 'Well, the only good news is the financial accelerator theory seems to be working,' " Gertler says. "This has guided his thinking and really motivated him to act very quickly."
Without quick action, their model shows, the situation rapidly falls apart.
Gertler says he hasn't asked the model to predict what comes next. But a colleague of his has been training the model on data from the past 20 years.
Simon Gilchrest, of Boston University, says the exercise has shown some clear results. "What the model is saying currently is we are experiencing a 2 percent decline in GDP growth because of these credit-tightening effects," he says.
In coming days, Gilchrest expects to use the Bernanke and Gertler model to look into the future. He wants to ask whether the $700 billion the Bush administration seeks for a bailout would be enough.