Heterodox economics, mainstream macro and the financial crisis

When heterodox economists want to argue against the mainstream, they typically start by talking about the failure to predict the financial crisis. This can be done in two different ways. One is to invoke Minsky, and talk about risk perception, leverage and the failure of the banking sector. I think this argument is accepted by mainstream macroeconomists, which is why there has been an explosion of DSGE and other microfounded analysis putting a financial sector into macromodels.

I just want to make two points on this. First, it is a sin of omission rather than signifying some fundamental flaw in existing macroeconomic theory. That is why financial sectors can be added to existing DSGE models: nothing has to be torn up and thrown away. Second, the fact that leverage was allowed to increase substantially before the crisis was not something that most macroeconomists were even aware of let alone approved of. As I have said before, if I had seen a chart showing bank leverage (like the one shown here) before the crisis I would have been extremely worried. It is true that Rajan’s warning in 2005 was famously knocked down by Summers, but it is a mistake to assume that most academic macroeconomists either agreed or disagreed with Summers: it just wasn’t their field. As Andy Haldane says, before the crisis

“prudential regulation was a niche academic issue. In my view, this absence of academic debate and challenge contributed, in no small measure, to international prudential standards being set at levels which were, with the benefit of 20/20 hindsight, not just too low but ridiculously too low.” (my italics)

There is a second strand to the heterodox attack on mainstream economists concerning the financial crisis, and that invokes not Minsky but Wynne Godley. Here I think heterodox economists also have a point, but they tend not to put it very well and, perhaps as a result, it has not yet impacted on the mainstream. Godley had, since the start of the millennium, raised alarm bells about rising US debt. The US savings ratio had been falling since the 1980s, but the personal sector had only gone into deficit at the end of the 1990s. (Michalis Nikiforos has a discussion.) Godley said this was not sustainable, and eventually he was proved right.

It is at this point that most heterodox accounts go wrong. They focus on the model he used to do his analysis, a model that tracks sector balances and their implications for sector wealth, but which otherwise has minimal behavioural content. This has become the “Stock-Flow Consistent methodology”, and it is inferred that mainstream models fail to impose stock flow consistency. But this is accounting, not economics, and was not unique to Godley. When I was a young economist at the Treasury in the 1970s, their UK model was ‘stock-flow consistent’, and forecasts routinely looked at sector balances. The model I built in the 1990s, which unlike the Treasury’s model included many of the theoretical features we now associate with New Keynesian models, also tracked sector balances. In terms of theory these were mainstream macromodels, but not microfounded macromodels.

It is trivial to add this accounting to any macromodel. The reason why it is typically ignored when it comes to the personal sector is because in most mainstream models these balances are of no consequence. Steve Keen points this out, but does not take the next step of asking why this is. The answer is because of the simplicity of the dominant mainstream model of intertemporal consumption, where there is no desired level of wealth or debt which consumers try to attain.

To understand the behaviour of both consumption and financial balances over the last few decades you need to understand the changing nature of credit availability from the financial sector. The best analysis I have seen of that comes from mainstream macroeconomists, and in particular Chris Carroll and John Muellbauer. (I first wrote about this here, but subsequently here.) Simply having a fixed proportion of credit constrained consumers does not get you there, because it cannot model what happens when credit constraints change.

Why did most mainstream macro ignore this work, and as far as I can see continues to ignore this work? It is not because their analysis sweeps aside the basic intertemporal consumption analysis of mainstream theory. Carroll’s analysis builds on that model and adds some basic real world elements like finite lives and income uncertainty. I think this work was/is ignored because incorporating this analysis into microfounded models raises serious problems associated with heterogeneity across age and income. As Carroll shows it is possible to do, but not easy to do. Playing around with habits or some ‘rule of thumb consumers’ is much easier. Blanchard has recently made a similar point in his critique of DSGE models.

In fact I would go further than this. I argue here that it was this microfoundations methodology that allowed mainstream macro to ignore the fall in personal savings in the US that preceded the crisis, because it is a methodology that allows you to be very selective about what empirical features you do or do not explain. As the best explanation for this decline in the savings ratio is easier credit, then any general equilibrium analysis would require modelling the financial sector. For this reason I speculate that had the microfoundations revolution been more tolerant of other methodologies (as it was in the UK until the end of the 1990s), macroeconomics may well have done more to integrate the financial sector into their models before the crisis. That is a rather different critique than the one typically offered by heterodox economists, but it is no less fundamental.

Mainstream macroeconomics addiction to microfoundations methodology has given heterodox economists an opportunity. If mainstream macro continues to shun what it calls policy models (models that use aggregate relationships justified by an eclectic mix of theory and data), then this space can be occupied by others. But to do that heterodox economists have to stop being heterodox, by which I mean defining themselves by being against almost all mainstream theory. As Jo Michell writes “The problem with heterdox economics is that it is self-definition in terms of the other”. As the scope and diversity of mainstream theory gets larger and wider, the space that can be occupied by those who reject the mainstream shrinks.