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!