The economy as a complex system: The balance sheet dimension

Given the economy's complex behavior and sudden transitions as evidenced in the 2007-2008 crisis, agent-based models are widely considered a promising alternative to current macroeconomic research dominated by DSGE models. Their failure is commonly interpreted as a failure to incorporate heterogeneous interacting agents. This paper explains that complex behavior and sudden transitions also arise from the economy's financial structure as reflected in its balance sheets, not just from heterogeneous interacting agents. It introduces "flow-of-funds" or "accounting" models, which were pre eminent in successful anticipations of the recent crisis. In illustration, a simple balance sheet model of the economy is developed to demonstrate that non-linear behavior and sudden transition may arise from the economy's balance sheet structure, even without any micro-foundations. The paper concludes by discussing one recent example of combining flow-of-funds and agent-based models. This appears a promising avenue for future research.