The failure of macroeconomics
Since the financial crisis there has been growing criticism of “economics”. From the Queen’s famous question “why did no-one see this coming?” to the Occupy movement and now to the Post-Crash Economics society founded by students at this university, people have questioned the purpose of an economics profession that failed to see the disaster approaching and seemed to have little coherent idea what to do about it.
Nonetheless, a blanket condemnation of "economics" as having failed is I think too wide. I therefore wish to narrow the framing. There are many economists out there doing important work, both in industry and in academia, on labour markets, on the behaviour of firms and households, on trade dynamics, on market functioning. I do not by any means wish to suggest that these have failed. Microeconomics, as a discipline, is going from strength to strength. My beef is with macroeconomics.
Olivier Blanchard, the IMF’s chief economist, recently wrote:
We in the field did think of the economy as roughly linear, constantly subject to different shocks, constantly fluctuating, but naturally returning to its steady state over time. Instead of talking about fluctuations, we increasingly used the term “business cycle.” Even when we later developed techniques to deal with nonlinearities, this generally benign view of fluctuations remained dominant.
The models that macroeconomic practitioners developed reflected this essentially linear view. Blanchard went on to observe that although macroeconomists did not ignore the possibility of extreme tail risk events, they regarded them as a thing of the past in developed countries. Western governments had inflation licked because of inflation-targeting central banks. Bank runs had been solved by deposit insurance and central bank lender of last resort functions. Sudden disastrous reversal of capital flows and balance of payments crises were problems for emerging market economies, not for developed European economies. And anyway, central banks could prevent or stop market “panics” by flooding the place with liquidity. If you get the policy settings right, linear models will work.
Except that they won’t. And that is because these models are not realistic views of how the economy actually works. Representative agents aren’t actually representative of anyone. Rational expectations are driven as much by emotion as logic. Behavioural economics is still in its infancy, but we are now beginning to understand just how much humans are driven by instincts such as herding. And nowhere is this more apparent than in the finance industry.
The financial crisis drew to our attention – once again – the crucial role of the finance industry. No industry that can cause such havoc when it goes wrong should ever be regarded as irrelevant or superficial. On the contrary: financial institutions perform the functions of capital allocation and money transmission which are so vital to our economy. Disruption or interruption of these functions, even if only for a brief time, has terrible consequences.
Yet macroeconomists regarded the behaviour of financial institutions and the motivations of those who work in the finance industry as so unimportant that they could safely be ignored. Representative agent models, flawed though they are, at least attempt to explain the behaviour of households and firms: but the behaviour of banks, and things that don’t call themselves banks but do bank-like things, stayed under the radar until far too late. Macroeconomists described the finance industry as a “veil”, rather than as the beating heart and circulatory system of the modern monetary economy: linear models, if they included banks at all, portrayed them as passive intermediaries, rather than active agents whose rational expectations are not necessarily aligned with those of their customers or, indeed, with the best interests of the economy as a whole.
The failure of most macroeconomists to foresee the financial crisis grew out of their incorrect understanding of how money is created, and perhaps more importantly, how leverage builds up. “Loanable funds” models, which portray the role of the financial sector as intermediating existing funds, are not only wrong, they are dangerous. They do not show how exuberance in credit creation arising from the irrational belief that asset values can keep rising forever carries the seeds of its own destruction. And they encourage belief in exogenous factors as the cause of financial crises – the “Asian savings glut” springs to mind. The huge increase in broad money prior to the financial crisis did not come from Asia, or from Mars. It was created by American and European banks.
Leaving banks out of economic models, or – worse – modelling their money-creating function incorrectly, made it impossible for mainstream economists to understand the significance of the build-up of credit that led to the financial crisis. The warnings came principally from people outside mainstream economics, particularly the followers of Hyman Minsky. After the crisis, Minsky’s “financial instability hypothesis”, long consigned to a dusty shelf in a dark cupboard, suddenly became hot news. Unsurprisingly, since we had just lived through something that looked very like a "Minsky moment".
Clearly, the exclusion of the financial industry from models of the macroeconomy was a major omission. Equally clearly, the fact that most macroeconomists did not, and to a large extent still do not, understand the mechanisms by which money is created and circulated in the modern monetary economy, is a big, big problem. Central banks are now “adding” the financial sector to existing DSGE models: but this does not begin to address the essential non-linearity of a monetary economy whose heart is a financial system that is not occasionally but NORMALLY far from equilibrium. Until macroeconomists understand this, their models will remain inadequate.
But macroeconomists are not oracles. It is their job to identify trends, not to predict specific events; it is both unreasonable and dangerous of the public to expect them to play the prophet. Macroeconomists have been cast in the role formerly held by priests and shamans, a role they appear to have welcomed though they are ill-equipped to perform it. They have garbed themselves with the cloak of infallibility and the breastplate of omnipotence. The financial crisis stripped them of these trappings, revealing them to be, underneath, somewhat skimpily clad.
It is fair to say that the academic macroeconomists have done a lot of soul-searching since the financial crisis, and there are important signs that things are beginning to change. But some of the most influential people in macroeconomics have spent their lives developing theories and models that have been shown to be at best inadequate and at worst dangerously wrong. Olivier Blanchard’s call for policymakers to set policy in such a way that linear models will still work should be seen for what it is – the desperate cry of an aging economist who discovers that the foundations upon which he has built his career are made of sand. He is far from alone.
At the Bank of England's One Bank Research Agenda seminar yesterday, Deputy Governor Ben Broadbent commented:
Economists cling to old ideas in the face of overwhelming evidence that they are wrong, or they choose the evidence that suits their particular framing.
Macroeconomics has indeed failed: not because of an intrinsic inadequacy in the discipline itself, but because of confirmation bias and selection bias among macroeconomists. Who would have thought it?
Topic: Economics.