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Wednesday, August 19, 2015

'Reform and Revolution in Macroeconomics'

This is something I've stressed with respect to the failure of macroeconomic models, the failure to ask the right questions prior to the crisis. There was no shortage of tools, though some -- like the restrictions imposed by representative agent modeling needed to be improved to better handle heterogeneous agents -- needed further development. The problem was that we had been told by the eminent thought leader(s) within the profession that the problem of deep recessions had been solved (if not by policy, then by the improvement in the operation of the economy brought about by modern technology -- markets were thought to function sufficiently well so as to avoid such problems, especially financial markets with their digital technology and physics brains). Thus, theoretical questions about deep recessions induced by financial panics were ignored or shunted off to the side (they seemed to lack empirical relevance at that time) and the profession focused on how to conduct policy in a "Great Moderation". So to answer why important questions were left largely unaddressed by mainstream models and thinking, it was a combination of the belief that the questions were unimportant combined with sociology within the profession that placed a lower value on pursuits that might have allowed us to be better prepared when the recession hit.

Simon Wren-Lewis argues there was ample reason to ask these questions if we had been more attention to empirical evidence:

Reform and revolution in macroeconomics: ...While it is nonsense to suggest that DSGE models cannot incorporate the financial sector or a financial crisis, academics tend to avoid addressing why some of the multitude of work now going on did not occur before the financial crisis. It is sometimes suggested that before the crisis there was no cause to do so. This is not true. Take consumption for example. Looking at the (non-filtered) time series for UK and US consumption, it is difficult to avoid attaching significant importance to the gradual evolution of credit conditions over the last two or three decades (see the references to work by Carroll and Muellbauer I give in this post). If this kind of work had received greater attention (which structural econometric modellers would almost certainly have done), that would have focused minds on why credit conditions changed, which in turn would have addressed issues involving the interaction between the real and financial sectors. If that had been done, macroeconomics might have been better prepared to examine the impact of the financial crisis. ...

[His main point is much broader.]

    Posted by on Wednesday, August 19, 2015 at 12:31 PM in Economics, Links | Permalink  Comments (11)


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