A macroeconomic puzzle

**Four years ago, the world was experiencing the worst financial crisis since the 1930s.** At the same time, a parallel crisis ensued within the macroeconomic discipline. Having missed the tail risk within the financial sector, economists faced the humiliating task of having to look for a new paradigm.

Four years on and there is still no new consensus. But even if a new consensus is reached, it will simply be the latest of the many paradigm shifts that have occurred in economic thought in the past 50 years. It is not surprising therefore that many believe that the study of macroeconomics is flawed from within. Whether this is true or not, it raises fair questions about how macroeconomics should be conducted.

Before the crisis, macroeconomic thought converged around a ‘New Keynesian’ consensus. The aim was to build macroeconomic theory on microeconomic principles, particularly ways that monetary policy could achieve macroeconomic goals like low unemployment and low inflation. For example, assuming that businesses expecting inflation in the future would raise prices today. If this were true, a central bank could control inflation by signalling policy direction through changes in the base interest rate – i.e. by managing inflation expectations. And since inflation and unemployment are usually negatively related, monetary policy could achieve both macroeconomic goals simultaneously.

But the narrow policy focus on macroeconomic stability ignored financial instability. Low interest rates led financial firms to look for ways to boost returns. The solution was twofold: increase leverage (financing by debt) and buy riskier products. In the first case, higher leverage made financial firms less resilient to shocks like subprime. In the second, when the market for riskier financial products collapsed in 2007, these assets became stranded on bank balance sheets. Faced with large write-downs, banks cut back on lending to the real economy and a recession ensued.

It always seems obvious in retrospect. How could economists miss the growing dangers within the financial sector? Pre-crisis models mostly took the working of financial markets as a given, despite the essential role of credit in facilitating investment. Since the crisis, economists have been trying to integrate financial markets into their models, but this belated effort does not answer why they missed the problem in the first place. If we cannot answer this question, then we are doomed to be surprised again in the future.

Indeed, macroeconomics has suffered many shifts in focus in the past, yet none has been permanent. Neo-Keynesianism focused on the role of fiscal policy in promoting full employment, but it was discredited by the stagflation of the 1970s. Monetarists focused on the role of money supply in creating inflation, but their popularity waned as money supply and inflation decoupled empirically in the 1990s. Economic theory, it seems, has a short sell-by date.

{{quote We cannot understand the behaviour of a single agent, let alone that of seven billion }}

Macroeconomics is prone to fads because of the nature of the subject. The economy is a complex system with innumerable parts and non-linear relationships. We can barely understand the behaviour of a single agent, let alone the combined behaviour of seven billion people. So economists are forced to use models which restrict analysis to a subset of ‘relevant’ factors. This is not entirely unreasonable as there are common factors that influence behaviour, e.g. unemployment is correlated across time. But it is a judgement call as to which factors to include in a model, and those we choose may wax and wane in relevance over time.

The problem of macroeconomics is therefore one of identification, which has two implicit dangers:

First, we have a tendency to overweigh recent experience. Currently the focus is on the link between financial instability and the real economy. But arguably this is the worst time to study financial instability since new regulation and investor memory reduces the immediate risk of another crisis. Past theory was a product of the times too, e.g. Keynesianism and the 1930s.

Secondly, slavishness to models suppresses nuanced thinking. Mathematical equations may be more elegant than a wall of text, but the latter allows you to appreciate the wider context. The pre-crisis consensus sacrificed breadth, analysing wider economic factors like the housing and finance, for depth, the desire to prove core dynamics in terms of microeconomic behaviour. Economists tend to explain too much and show too little.

What macroeconomics requires, therefore, is more than a new paradigm: it requires a better way of thinking. Macroeconomics will never reach predictive precision because of the economy’s internal complexity. So if macroeconomics is to restore its reputation, then intellectual honesty is an essential prerequisite. That will require economists to adopt a more historical approach. This may not always owe itself to elegant solutions, or prevent paradigm shifts, but it would guard against the risk of overlooking broader economic developments