Joseph Stiglitz says adding bells and whistles to the current vintage of macroeconomic models will not fix what is wrong with them, "Nothing less than a paradigm shift will do":
Needed: a new economic paradigm, by By Joseph Stiglitz, Comentary, Financial Times: The blame game continues over who is responsible for the worst recession since the Great Depression – the financiers who did such a bad job of managing risk or the regulators who failed to stop them. But the economics profession bears more than a little culpability. It provided the models that gave comfort to regulators that markets could be self-regulated; that they were efficient and self-correcting. The efficient markets hypothesis ... ruled the day. Today, not only is our economy in a shambles but so too is the economic paradigm that predominated in the years before the crisis – or at least it should be.
It is hard for non-economists to understand how peculiar the predominant macroeconomic models were. Many assumed demand had to equal supply – and that meant there could be no unemployment. (Right now a lot of people are just enjoying an extra dose of leisure; why they are unhappy is a matter for psychiatry, not economics.) Many used “representative agent models” – all individuals were assumed to be identical, and this meant there could be no meaningful financial markets (who would be lending money to whom?). Information asymmetries, the cornerstone of modern economics, also had no place: they could arise only if individuals suffered from acute schizophrenia, an assumption incompatible with another of the favored assumptions, full rationality.
Bad models lead to bad policy: central banks, for instance, focused on the small economic inefficiencies arising from inflation, to the exclusion of the far, far greater inefficiencies arising from dysfunctional financial markets and asset price bubbles. After all, their models said that financial markets were always efficient. Remarkably, standard macroeconomic models did not even incorporate adequate analyses of banks...: even a cursory look at the perverse incentives confronting banks and their managers would have predicted short-sighted behavior with excessive risk-taking. ...
Fortunately, while much of the mainstream focused on these flawed models, numerous researchers were engaged in developing alternative approaches. ... With a few exceptions, most central banks paid little attention to systemic risk and the risks posed by credit interlinkages. Years before the crisis, a few researchers focused on these issues, including the possibility of the bankruptcy cascades that were to play out in such an important way in the crisis. This is an example of the importance of modeling carefully complex interactions among economic agents (households, companies, banks) – interactions that cannot be studied in models in which everyone is assumed to be the same. Even the sacrosanct assumption of rationality has been attacked: there are systemic deviations from rationality and consequences for macroeconomic behavior that need to be explored.
Changing paradigms is not easy. Too many have invested too much in the wrong models. Like the Ptolemaic attempts to preserve earth-centric views of the universe, there will be heroic efforts to add complexities and refinements to the standard paradigm. The resulting models will be an improvement and policies based on them may do better, but they too are likely to fail. Nothing less than a paradigm shift will do.
But a new paradigm, I believe, is within our grasp... What is at stake, of course, is more than just the credibility of the economics profession or that of the policymakers who rely on their ideas: it is the stability and prosperity of our economies.