Posted by: Dirk | September 5, 2008

Macroeconomic theory – where is the explanatory power?

Joe Stiglitz gives his account of the US economic crisis at the New Republic. Here are some issues:

Resources were misallocated and risks were mismanaged so severely that the private sector had to go running to the government for help, lest the entire system melt down.

Blame has rightly fallen on the financial markets because it is their responsibility to allocate capital and manage risk, and their failure has revived several old concerns of the political (and economic) left.

Behind the subprime crisis were mortgages designed to encourage repeated refinancing of homes–a pyramid scheme that generated billions of dollars in fees for the mortgage company as long as home prices continued to soar. It was inevitable that the bubble would break.

The current woes in America’s financial system are not an isolated accident–a rare, once-in-a-century event. Indeed, there have been more than one hundred financial crises worldwide in the last 30 years or so.

Now let’s take a look at the New Keynesian modelling approach,  state-of-the-art macroeconomics, which ‘combines the DSGE strucre characteristic of RBC models with assumptions that depart from those found in classical monetary models. Here is a list of some of the key elements and properties of the resulting models:’ (Gali 2008, p.5)

– Monopolistic competition.
– Nominal rigidities.
– Short run non-neutrality of money. As a consequence of the presence of nominal rigidities, …

So, if you want to use macroeconomic theory to talk about the current financial crisis, how are you supposed to do it? I find it incredibly hard. Where do you start? Monopolistic competition? The mortgage mess was not about price settings by private economic agents, it was a Ponzi scheme leaving banks loaded up with non-performing loans. These bank wouldn’t lent to each other, which caused stress in the interbank money market. Nominal rigidities? Short-run non-neutrality of money? Sure, but not as a consequence of nominal rigidities. How do these things fit in? And it’s not that the financial crisis is out of the ordinary. The last US recession was the burst of the internet bubble. It’s just that I cannot see the relevance of these models right now, when it matters most. This is all puzzling to me.

However, the good old idea of hoarding seems to be useful when talking about financial market stress, but this concept is not part of the modern theories anymore. We are all Keynesians? Maybe, but John Maynard Keynes and his ideas (like the General Theory, ch. 12, VII below) are half forgotten, it seems:

The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only. But a little consideration of this expedient brings us up against a dilemma, and shows us how the liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment. For the fact that each individual investor flatters himself that his commitment is “liquid” (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are available to the individual. This is the dilemma. So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive (especially to the man who does not manage the capital assets and knows very little about them), except by organising markets wherein these assets can be easily realised for money.

The only radical cure for the crises of confidence which afflict the economic life of the modern world would be to allow the individual no choice between consuming his income and ordering the production of the specific capital-asset which, even though it be on precarious evidence, impresses him as the most promising investment available to him. It might be that, at times when he was more than usually assailed by doubts concerning the future, he would turn in his perplexity towards more consumption and less new investment. But that would avoid the disastrous, cumulative and far-reaching repercussions of its being open to him, when thus assailed by doubts, to spend his income neither on the one nor on the other.

UPDATE 08/09/2008: Paul Krugman in the NY Times points to Irving Fisher’s (1867-1947) debt deflation theory in today’s column, in which he laments that the US is on its way to imitate Japan’s recent decade-long slump. Here’s the relevant excerpt:

As the economist Irving Fisher observed way back in 1933, when highly indebted individuals and businesses get into financial trouble, they usually sell assets and use the proceeds to pay down their debt. What Fisher pointed out, however, was that such selloffs are self-defeating when everyone does it: if everyone tries to sell assets at the same time, the resulting plunge in market prices undermines debtors’ financial positions faster than debt can be paid off. So deflation in asset prices can turn into a vicious circle. And one consequence of what he called a “stampede to liquidate” is a severe economic slump.

UPDATE 14/10/2008: Justin Wolfers at Freakonomics asks Where Have All the Macroeconomists Gone?, then picks up the trail once more, plus one comment on textbooks by Stephen Dubner . Also, I found a nice quote of John von Neumann (undated). My criticism with macro models is the part they I have highlighted:

The sciences do not try to explain, they hardly even try to interpret, they mainly make models. By a model is meant a mathematical construct, which with the addition of certain verbal interpretations, describes observed phenomena. The justification of such a mathematical construct is solely and precisely that it is expected to work.



  2. That depends on the models you are looking at. Some recent models don’t say anything on loans, while loans were already part of Knut Wicksell’s 1898 classic “Interest and prices”. There, money demand is determined by demand for loans by firms eager to invest. Of course, loans have appeared in later models as well and are part of central bank models as well. Although until recently many economists followed Alan Greenspan’s argument that it is not the central banks task to spot and disinflate bubbles in financial markets. But that has surely changed by now. To sum it up, there are some models that can be used to analyze financial crisis, while others fail to even mention the important issues. If you are familiar with the Keynesian IS/LM model, you can compare our current situation to the liquidity trap, where traditional (and even exotic) monetary policy is without effect.

  3. You might find this thread (on a forum for prospective econ phd students) amusing:

  4. […] to model the financial crisis? Recently, I have noted that most macroeconomic models have big difficulties to explain the ongoing financial crisis. Then, why […]

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