Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday 19 January 2014

Will the financial crisis lead to another revolution in macroeconomics?

This question was prompted both by an earlier post, and by reading Martin Wolf’s excellent 2013 Wincott Memorial lecture. (The response by Robert Skidelsky is also worth reading.) In the lecture he in characteristic style tries to demolish the idea that we have permanently lost a large amount of productive potential, and also argues that we need to fundamentally rethink the role of the financial sector. Bravo to that. He also says that the financial crisis “calls for an intellectual upheaval reminiscent of the response to depression in 1930s and then to inflation in the 1970s.” It is this last idea that I want to explore here.

That the depression led to Keynesian economics, and that this revolutionised macroeconomics, cannot be disputed. If the great inflation of the 1970s did a similar thing, then we might indeed expect something similar to follow from the financial crisis of 2007-9. Yet it is far from clear to me that it did. It greatly increased, for a while, the popularity of monetarism, but in theoretical terms that was hardly revolutionary (it used IS-LM), and its popularity died out pretty quickly. The adoption of monetary policy as the stabilisation tool of choice owed something to monetarism, but it probably owed much more to the move to flexible exchange rates when Bretton Woods collapsed. Friedman’s reinterpretation of the Phillips curve was important, but it was not revolutionary.

There was a revolution in macroeconomics in the 1970s and 1980s, but it was a counter revolution, as the name New Classical implies. It was essentially a revolution inspired by theory (rational expectations, and microfoundations more generally), rather than external events. There is no obvious link with the great inflation of the 1970s. Indeed, the RBC model that embodied most of the ideas of that revolution had essentially nothing to say about inflation.

So, in this straightforward sense, the great inflation of the 1970s did not lead to a revolution in macroeconomic thought. This suggests that there is no inevitability that the financial crisis will lead to any revolution in macroeconomics. Everyone admits that mainstream macro analysis took finance for granted before the crash, and those economists that did worry about such things were marginalised. (I would want to add Greenwald and Stiglitz to the usual list.) But now ‘financial frictions modelling’ is the growth area within the discipline. However this explosion of work does not appear revolutionary, but just another example of adding particular ‘frictions’ or ‘market imperfections’ to standard models.

As yet there is no sign that the financial crisis is about to lead to any paradigm shift in macro, even if some might wish it so. I can think of three ways the reaction to the financial crisis could lead to major evolutionary changes over time. First, it may end the tyranny of the consumption Euler equation, and finally give agent’s asset positions the key role they deserve in understanding their behaviour. (See this earlier post of mine, or this more recently from Noah.) Second, the need to incorporate financial frictions, and other balance sheet effects for households and firms, while retaining the many essential features of the macroeconomy (e.g. labour market search, sticky prices) may require (for tractability) a gradual softening of the microfoundations methodology. I doubt that this will involve any sudden change, but just the increasing use of tricks like Calvo contracts that allow modellers to use aggregate equations that work empirically. Third, and most speculatively, I suspect we will see real attempts to model in a behavioural way changing attitudes to risk.

So, just as the great inflation of the 1970s in itself led to an evolution rather than a revolution in macro, we might see something similar following the Great Recession. However, to be a little controversial, perhaps there is a more indirect link between the great inflation and the New Classical revolution, which involves ideology. I think you could argue that the events of the 1970s led to an intellectual revolution in the sense of promoting neoliberalism and questioning the value of collective action in the form of both state intervention and trade unionism. That did not require any revolution in economics, because it came from (a selective reading of) the existing economics playbook. However you could argue (in a rather functionalist way) that Keynesian economics was too great a counterexample to the neoliberal view of the world, and therefore had to be overturned. A counterrevolution was required. I’m not sure how important this is, because I still think the main reason New Classical ideas won out against traditional Keynesian theory was that they won the intellectual argument. However I have also learnt in the last few years not to underestimate the role of ideology in economics. 

If you think this argument has some merit, then you might continue as follows. Although the financial crisis may not have exposed fundamental flaws in macroeconomics (just fundamental gaps), it should have exposed the failure of neoliberalism as an ideology. Finance was the poster boy of neoliberalism, where unfettered rewards and deregulation would generate innovation that helped fuel economic growth. The financial crisis led to the complete collapse of that story, with the whole sector having to be rescued by the state, and causing a prolonged recession. Yet the growing rewards continue regardless. It is now clear that these excessive rewards come not from innovative dynamism but either from rent seeking, or from risk taking supported by an implicit state subsidy (pdf). While the political forces that benefited from neoliberalism are strong, the bankruptcy of that ideology, and the harm done by the inequality it generated, are too great a truth to be resisted for long.

If that turns out to be true, then there may be some implications for macro. Theories that find support not from evidence but from the neoliberal positions they help justify may begin to be seen as the unacceptable face of the discipline. Conformity with most rather than just some of the evidence may start to matter more than conformity with a simple microeconomics that idealises the market. But this sounds too much like wishful thinking, so I suspect there is something wrong with the argument!


  1. Seisachtheia. That was what happened in the time of Solon. Realisation that property rights cannot be supported to their ultimate conclusion. Because property can be used to generate more wealth. Ultimately leading to more and more inequality. Until the system becomes inefficient and collapses. If we realise the problem, a New Deal can come either in time, or after collapse.

    I don't know what exactly the 'neoliberal position' is. But it seems that it is unsustainable in exactly this fashion. And macro policy has been used to bolster property rights by keeping inflation low. Supporting a free market that helps those with capital to make more, using a financial industry that can create more money for those that have equity, to invest in making ever more of it. While endebting the majority.

    So at a time of climate change, biodiversity loss, and a need to engineer a transition of our whole system of using energy, while our population growth is slowing down (and it needs to), we have an economy that is not able to invest in these challenges. Our economy is less able to provide equal opportunity of education to all our youth. Our economy cannot create the necessary paid jobs to take on these challenges. We are no more able to efficiently use money as a device that is passed around among us, to make sure everybody is occupied on some useful work, with a reasonable pay.

    Hmm.. maybe I'm being too obscure. But there's a lot of things coming together now. And macro economics is part of it.

  2. Isn't neoliberalism just a shorthand way of saying "the prevailing ideology" of the era? It's the prevailing ideology because no one questions its truth. Inflation is evil and must be avoided at all cost, even though the solution to inflation is easy and straight-forward. Inflation is the great evil yet according to social surveys the people of the UK in the 1970's were never happier. My father, a union man, never graduated from high school but he explained economics to me in a way I'll never forget, "If he worries about unemployment he's for the workers, and if he worries about inflation he's with the coupon clippers(bond holders)."

  3. The financial crisis showed the complete and utter failure of modern economics. And why shouldn't it fail? What is the price of failure for economists? Not all that much.

    Take a system where the successful don't receive sufficient reward, and the mediocre and failed aren't punished sufficiently, and over time what will happen? Well, let's just say it's not a good thing.

    If you want to fix the problems then start by putting economists in charge who saw the 2008 financial crisis coming.

  4. "I still think the main reason New Classical ideas won out against traditional Keynesian theory was that they won the intellectual argument."

    And even admitting (for the sake of the argument) that they did, would you reckon they still do?

  5. I agree with Simon’s last two paragraphs which suggest that the blatantly corrupt nature of our existing banking system may lead changes in macro. I suspect the changes will be roughly as follows.

    Fractional reserve banking cannot exist without the subsidies to which Simon refers. Ergo those subsidies will disappear, which means replacing fractional with full reserve banking. But the latter is a system under which base money is dominant and commercial bank created money is near non-existent.

    And that in turn would lead to significant changes in the way monetary fiscal policy are implemented. The changes are too complicated to set out here (says he: pretending he understands them all).

  6. What about the proposition that in a functioning housing market in real terms prices should depreciate over the medium term, and if that does not happen and is replaced by boom and bust, then the market does not work.

    Isn't that a theoretical Trojan horse?

  7. I’m not sure how important this is, because I still think the main reason New Classical ideas won out against traditional Keynesian theory was that they won the intellectual argument.

    Did they? It is like saying they found the answer to the meaning of the universe.

    Of course they did not win this or any intellectual argument. The reasons for its dominance are mundane - a lot of technicians in the discipline who like to use maths, and this type of economics suits maths compared with Keynesian economics which is better suited to less tangible normative things - like the real world. In the real world, and for people doing what they should be doing - finding a way to make the world a better place, especially for the disadvantaged, that is what matters.

  8. New Classical economics is particularly unsuited to understanding the complexities and contradictions of how the world actually works.

  9. Just a comment from an amateur observer.

    It seems macro does not put sufficient emphasis on aggregate wealth, especially that wealth represented by capital assets. And then when it considers flows it does not seem to make the connection between the yields on capital assets and the resulting flows. And further there is little consideration of who owns the capital assets, especially those held by the public and not recorded on any balance sheet.

    One might think that this would be a "coupon clipper's" perspective, but had we leaders in 08 cognizant of he effects of the bust on capital assets, perhaps they would have acted quickly to preserve their values and yields, which would have been much different from what they did, which was acting to guarantee financial assets.

  10. The financial crisis certainly changed research programs, both in academia and in policymaking institutions, e.g. central banks. For the best evidence on this, you should look at what fresh PhDs are doing. I don't think you'll see any revolution in methodology there. The focus has shifted dramatically to topics involving financial economics, in part at the expense of sticky wages and prices. Sometimes the sticky prices/wages are thrown in there, but it's not a focus of the research. Further, I don't think you'll find any more work on behavioral economics than before the crisis.

    1. I think we agree that financial frictions etc is THE hot topic, and this is being tackled using the standard methodology. I’m not sure the absence or otherwise of sticky prices in these models necessary indicates anything more than the usefulness of parsimony. As I said in my post, my comment about behavioural models involving risk was speculative, precisely because – as you say – there is no evidence for it as yet. Let me say why I added that in, because I would be interested in your views.

      I think much of the financial frictions modelling I have seen continues to treat the genesis of the crisis as an exogenous shock. A sudden reduction in the quality of bank capital for example. It then traces the propagation mechanism of that shock. Equally it looks at how adding a financial sector might influence the transmission mechanism of traditional macro shocks. (Sometimes not that much e.g. in some BGG type models.) This is fine to start with, but it leaves unanswered whether macro conditions may or may not have facilitated the crisis - was the shock at least partly endogenous. Equally much financial economics is content to treat attitudes to risk as just like a preference parameter. (An exception is some work I’ve seen looking at the role of low real interest rates.) But another possibility is to try and at least partially endogenise attitudes to risk. Do you think this is a silly idea?

    2. "I think much of the financial frictions modelling I have seen continues to treat the genesis of the crisis as an exogenous shock."

      Yes, I don't like that either, though I probably shouldn't say it, as I've done it myself. What exactly is a financial crisis shock? I think that's a deep question. There seem to be two ways to think about it. One is multiple equilibria, in which case it's endogenous. The other is some sort of amplification effect - a small underlying shock has large aggregate effects.

      "Equally much financial economics is content to treat attitudes to risk as just like a preference parameter."

      I think some of what we want to capture can be done by thinking about private information. For example, the environment becomes more "risky" for a financial institution. Why? Because this institution knows that the likelihood of default is higher for some other financial institutions or individuals. But there is poor information on who those institutions and individuals are. That's part of what systemic risk is about.

    3. A lot of the discontent Skidelsky mentioned has been led by undergraduates. But undergraduates are a diverse lot, some more humanities/historian types, others more geared towards the pure sciences. However at the graduate level it is dominated by physics/engineering/mathematics types. This is self serving. The more the discipline isolates itself from the humanities and other social sciences, the more it attracts this type of graduate, and so the cycle goes on. Forcing graduates to take 101 courses in history, philosophy, political science etc and forcing them to read complex books and write on complex subjects in a holistic way is the way to deal with this.

  11. "the main reason New Classical ideas won out against traditional Keynesian theory was that they won the intellectual argument."

    Yes, and no. Here's the problem with that claim. Keynesian theory is fundamentally depression economics (not recession economics, but depression economics). So in the long post WWII period where there were no depressions, of course Keynesian theory didn't appear as relevant.

    But this is like saying diet and exercise are more important to health than chemotherapy. Well, yeah, as long as you don't have cancer, you don't need chemo, and diet and exercise are pretty important to staying healthy.

    The question is, what happens when you get sick.

    The evidence is overwhelming that Keynesian economics is really really good for depression conditions in the economy. And it turns out the diet and exercise regime recommended by the latest version of mainstream economics is not sufficient for returning the economy to health.

    Mark Thoma quipped the best new economics is in all the old text books. If he's even half right by humor, who needs a revolution? It's obvious the economy is demand starved, its clear why, and all the old text books have a remedy. We collectively should spend. Spend on what? why anything'll do, but investing in all the many resources of the country would be optimal.

    This suggests the required revolution: dump the 'always and everywhere mindset'. We know that sometimes many hands make light work, and sometimes too many cooks spoil the broth.
    The revolution could be accepting that both can be true, depending...

    In the US the standard little proverb that describes the current state of affairs in Economics that makes claims at universality is the Arkansas traveler.

    A traveler was riding by that day,
    And stopped to hear him a-practicing away;
    The cabin was a-float and his feet were wet,
    But still the old man didn't seem to fret.
    So the stranger said "Now the way it seems to me,
    You'd better mend your roof," said he.
    But the old man said as he played away,
    "I couldn't mend it now, it's a rainy day."

    The traveler replied, "That's all quite true,
    But this, I think, is the thing to do;
    Get busy on a day that is fair and bright,
    Then patch the old roof till it's good and tight."
    But the old man kept on a-playing at his reel,
    And tapped the ground with his leathery heel.
    "Get along," said he, "for you give me a pain;
    My cabin never leaks when it doesn't rain."

    1. The evidence is overwhelming that Keynesian economics is really really good for depression conditions in the economy.

      Not only depression. What economics in the end was used in 2008? Purchases of debt on a large scale to get a private sector in a malaise is what Keynes advocated. What did the 30 years of economics before 2008 give us when it came to the real test? In the end they had to look at what was done over half a century before. Great progress in learning!

      The fact that these guys who did all that useless stuff still dominate the profession is not only a scandal, it is a tragedy.

  12. "Although the financial crisis may not have exposed fundamental flaws in macroeconomics (just fundamental gaps), it should have exposed the failure of neoliberalism as an ideology."

    Am I missing something here or is someone trying to turn tables on our face? Do you call neoliberalism handing loans to unqualified individuals? To me this is more like socialism that tries to put the blame on a doctrine that was never truly implemented ever and nowhere. The crisis was due to the failure of socialism in a time that right parties have assumed elements of left parties and left parties have assumed elements of right parties so that they can both steal voters. The result is a failure of the system because in any multi-dimensional system compromised middle positions are impossible and the only solutions that are valid are the extreme ones. You ought to reconsider your irrational stand.

  13. The possible alternative that at least some people are pursuing and there are several major conferences coming up dealing with, although papers on this have not been able to get published in the top 5 journals, is the ABM or agent-based modeling approach. One might argue this is not revolutionary, but it more sharply breaks with both the Euler consumption equation and the broader DSGE framework as well.

    I would argue that this is where behavioral econ can come in to assist in providing a more reasonable micro-foundation for macro, based on empirically observable behaviors by agents, with some of these models in fact being able to endogenously generate the financial fluctuations, unlike the models that add fin frictions to DSGE models and still need an exogenous shock to make their frictions aggravate the shock.

    Barkley Rosser

  14. Let me note for those who have not seen any of these models, and there are quite a few running around out there, many of them derive from the Santa Fe/Brock-Hommes approach, the latter in its pure theoretical form being published in Econometrica in 1997, although it was not itself an AB macro model.

    So, the basic story is that agents use heuristics for decisionmaking, and within their bounded rationality they adjust their heuristics over time based on their performance relative to others. With full rationality they adjust instantly and perfectly all the time, but otherwise they do so more slowly, with the speed of this a crucial parameter determing system dynamics. In any case, it is not hard for models of this sort to generate oscillations between periods where dominating heuristics are destabilizing herd type that generate bubbles and those that are stabilizing and more like standard ratex models, with these oscillations endogenously arising.

    BTW, more than one policymaker at central banks has called for more research along these lines in their research shops, but for whatever reason those places are not hiring the people who do this stuff, at least not very much.

    Barkley Rosser

  15. How well is the neo-lib model working, well if you happen to be one of the 85 great if you happen to be one of the 3.5 billion not so well. I am some where in the middle not one of the 85 but I think one of the upper 3.5 billion. Trouble is the 85 spend a lot less and pay less tax than the remaining 3.5 billion. Hence the mess we are in.

  16. Macro-economics as currently constituted is facing the same problem Marxist theorists faced when the Soviet Union collapsed. The Marxists, save for a few die hards, recognized the failure of their theories and conceded. In contrast, our economists have simply decided to become irrelevant save as paid shills that make Soviet apparatchiki look like serious critical thinkers. It might be embarrassing, but it pays well.

  17. Another thing not looking auspicious for a balanced type of economics in the future. The BBC has reported recently that the number of women taking A level maths, physics and economics has fallen dramatically in recent years.

    Expect more Sargents, Lucas's, Prescotts and Cochranes.

  18. Lorne Carmichael23 January 2014 at 16:25

    Well, it's been a long time since I took macro in grad school, but now that I'm old perhaps I can add something useful to this list of comments.

    Back when, one of the issues in macro was the “short run productivity problem”. In a competitive model, negative demand shocks should lead to an increase in labour productivity as firms shed labour and move up their marginal product of labour curves. This doesn't happen of course – productivity goes down in recessions. At the time we all mumbled something about “specific capital” and “labour hoarding”, but this doesn't work. If you are a competitive firm you can sell all you want at the going price. So in competitive equilibrium labour hoarding predicts huge price fluctuations. Imposing sticky prices at the macro level doesn't help – at the level of a competitive firm prices are always sticky.

    Rational expectations doesn't address this issue, but then along came real business cycle theory. What if, all of a sudden, all the auto workers got up one morning and discovered they had forgotten how to make cars? Productivity would go down, and we'd have a recession!

    This stunningly stupid idea somehow took over our profession. How on earth could this happen? I think there were two reasons. The first is ideological. It allowed economists to continue modelling in the competitive framework and therefore continue appealing to the welfare theorems in their defence of rich people and their right to keep all their money. The second has more to do with the needs of an academic profession. At the time there really wasn't a lot to be learned about a student from yet another thesis that estimated yet another demand for money equation. But this new approach afforded lots of opportunities for people to display their creativity and intelligence and work their way up the ranks.

    One of the questions I sometimes ask my students is to suppose that they were the CEO of a company – any kind of company – and they were offered a device that when put on their desk and switched on would increase their sales by 10%. Everything else including all prices would stay constant, but sales go up by 10%. Would you use the device? How many CEO's would do so?

    Retail markups over marginal cost are huge. Wholesale markups over marginal cost are huge. Just about every firm on this planet would welcome an increase in sales. None of them is perfectly competitive.

    This is where the much needed revolution in Macro has to start.

    1. I think there were two reasons.

      There was another. A big one was the collapse of the Soviet Union which led to triumphalism from the right. Anything seen to do with government - welfare states, taxation, regulation was seen as getting in the way of the free market and capitalism which was now proved to be unquestionably more efficient and superior.

      For a profession largely lacking in good historical methodological practice and critical reasoning, this interpretation of events proved irresistible.

  19. Please see:

    An Equilibrium Model with Involuntary Unemployment at Flexible, Competitive Prices and Wages; John Roberts. The American Economic Review, Vol. 77, No. 5 (Dec., 1987), pp. 856-874.

    This paper posits a different kind of economy wide equilibrium (game theory) where agents make prices but behave competitively. In that context, the paper shows that unemployment can be an equilibrium state. The approach seems to indicate that financial market malfunction and a liquidity trap can be permanent fixtures as well. I am not qualified to work through this, but I think this might be important. Might it be that what went wrong with the micro foundations for macroeconomics was that the modelers built on the wrong microeconomic model of equilibrium. Take a look and think about it.

  20. If Japan gets hyperinflation there will be a revolution in thinking about the cost/benifits tradeoff for fiscal and monetary stimulus.

  21. The depression in the 1930s gave us Keynes and stagflation in the 70's gave us Freidman and I am pretty sure there will be a new luminary to rise from the ashes of the current mess we are in. Frankly, neither of the "old schools" looks likely to predict the "first best solution" correctly.

    Keynesians really struggle to find an elegant solution to the ending current cash hoarding and low private sector investment when their demand side policies would further raise public debt. Why would a company or an individual risk investing in new ventures in a country where sovereign debt is increasingly out of control and where there is a risk of default or very high interest rates in the future(particularly when most investors are not followers of Keynes)? The risk of slowly reducing asset value is always preferable the risk of a total loss investment. Keynesian's offer no insights into how this conundrum is resolved.

    In the same way monetarist struggle to solve the problem of very low private sector investment when real interest rates have been are are likely to be negative for years to come. They argue for more public sector austerity, that would reduce demand and further endanger recovery. They also can’t resolve the problem that supply side solutions would further erode labour share (the % of national income earned by employees), which is one of the main reason for falling demand and productivity.

  22. nice blog ..thank you for sharing the information...

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