Crisis, what crisis? Arrogance and self-satisfaction among macroeconomists

                My recent post on economics teaching has clearly upset a number of bloggers. There I argued that the recent crisis has not led to a fundamental rethink of macroeconomics. Mainstream macroeconomics has not decided that the Great Recession implies that some chunk of what we used to teach is clearly wrong and should be jettisoned as a result. To some that seems self-satisfied, arrogant and profoundly wrong. I’ve already mentioned one example, but here is David Ruccio, who asks in contradiction “What I want to know is, which part of that theory doesn’t need to be reexamined in light of the events of the past few years?”

                He then gives some examples. The first is a bit annoying. He says “where is the history of the theories and debates that have taken place in macroeconomics since at least the publication of John Maynard Keynes’s General Theory?” It’s annoying because I ended my post making exactly this point, and arguing that some account of this history of macroeconomic thought should be brought into the teaching of the macroeconomics core. But the issue I want to focus on here is why I don’t think the financial crisis requires a fundamental rethink of macroeconomics, despite articles in the media (e.g. here) suggesting is should.

                Let me be absolutely clear that I am not saying that macroeconomics has nothing to learn from the financial crisis. What I am suggesting is that when those lessons have been learnt, the basics of the macroeconomics we teach will still be there. For example, it may be that we need to endogenise the difference between the interest rate set by monetary policy and the interest rate actually paid by firms and consumers, relating it to asset prices that move with the cycle. But if that is the case, this will build on our current theories of the business cycle. Concepts like aggregate demand, and within the mainstream, the natural rate, will not disappear. We clearly need to take default risk more seriously, and this may lead to more use of models with multiple equilibria (as suggested by Chatelain and Ralf, for example). However, this must surely use the intertemporal optimising framework that is the heart of modern macro.

                Why do I want to say this? Because what we already have in macro remains important, valid and useful. What I see happening today is a struggle between those who want to use what we have, and those that want to deny its applicability to the current crisis. What we already have was used (imperfectly, of course) when the financial crisis hit, and analysis clearly suggests this helped mitigate the recession. Since 2010 these positive responses have been reversed, with policymakers around the world using ideas that contradict basic macro theory, like expansionary austerity. In addition, monetary policy makers appear to be misunderstanding ideas that are part of that theory, like credibility. In this context, saying that macro is all wrong and we need to start again is not helpful.

                I also think there is a danger in the idea that the financial crisis might have been avoided if only we had better technical tools at our disposal. (I should add that this is not a mistake most heterodox economists would make.) A couple of years ago I was at a small workshop organised by the Bank of England and ESRC, that got together mostly scientists rather than economists to look at alternative techniques of modelling, such as networks. One question is whether finance and macro could learn anything from these other disciplines. I’m sure the answer is yes, and I found the event fascinating, but I made the following observation at the end. The financial crisis itself is not a deeply mysterious event. Look now at the data on leverage that we had at the time, but too few people looked at before the crisis, and the immediate reaction has to be that this cannot go on. So the interesting question for me is how those that did look at this data managed to convince themselves that, to use the title from Reinhart and Rogoff’s book, this time was different.

                One answer was that they were convinced by economic theory that turned out to be wrong. But it was not traditional macro theory – it was theories from financial economics. And I’m sure many financial economists would argue that those theories were misapplied. Like confusing new techniques for handling idiosyncratic risk with the problem of systemic risk, for example. Believing that evidence of arbitrage also meant that fundamentals were correctly perceived. In retrospect, we can see why those ideas were wrong using the economics toolkit we already have. So why was that not recognised at the time? I think the key to answering this does not lie in any exciting new technique from physics or elsewhere, but in political science.

To understand why regulators and others missed the crisis, I think we need to recognise the political environment at the time, which includes the influence of the financial sector itself. And I fear that the academic sector was not exactly innocent in this either. A simplistic take on economic theory (mostly micro theory rather than macro) became an excuse for rent seeking. The really big question of the day is not what is wrong with macro, but why has the financial sector grown so rapidly over the last decade or so. Did innovation and deregulation in that sector add to social welfare, or make it easier for that sector to extract surplus from the rest of the economy? And why are there so few economists trying to answer that question?


Postscript. As Richard Portes points out to me, the last sentence is a little unfair: see here and here, for example