The financial crisis and the ensuing recession have prompted reappraisals of the state of macroeconomic theory. Opinions differ on how serious are its problems but critics and defenders alike are agreed that they should be addressed by systematically examining and, where deemed necessary, modifying the assumptions of the reigning dynamic stochastic general equilibrium theory.
This is a rather natural reaction to conceptual failure. But is it the right strategy?
- How many critical assumptions are there that need to be re-examined?
- What is the framework within which we identify the assumptions that seem critical?
- How do we count the presumptions of which we may not even be aware?
Macroeconomics by now has a long history of responding to troubles besetting the theory prevailing at any given time by changing one or more of its assumptions – and then moving on from there.
But this collective strategy seems now to have landed us in a worse mess than ever. Might our problems lie deeper?
In a new Policy Insight, Axel Leijonhufvud takes a look back at the evolution of macroeconomic theory, going from Keynes’ General Theory to the New Neoclassical Synthesis, passing by Friedmanian Monetarism, Real Business Cycles and Rational Expectations.
Important as these advances in our knowledge of how markets work undoubtedly are, our understanding of how an economy works has failed to progress in one important respect. The Old Neoclassical Synthesis, which saw the economy as a stable general equilibrium system hampered by the frictions of sticky wages, drew the wrong lesson from the Great Depression and the dramatic wage deflation that it caused in the US. The New Neoclassical Synthesis has brought us back full circle to this notion of the economy as a stable general equilibrium system with frictions. It does not recognise the instabilities lurking in the economic system.
The image of a capitalist economy as a stable general equilibrium system somewhat hampered in its functioning by “frictions” is, according to Leijonhufvud, an inadequate guide to the realities we have to cope with. Indeed, he argues that it is in the nature of an economy to harbour the possibility of serious instabilities.
Let's change how we do economics
If we are to get better at understanding the economy, Leijonhufvud suggests that we have to think of an economy as an “open system” in the ontological sense. This will require us to adapt our methods to the nature of an economy – to change how we do economics.
Macroeconomics in the years leading up to the recent crisis had become a technically demanding subject and was naturally dominated by people who were good at that sort of thing. But unless you took much pride and joy in its technical aspects, it had also become deadly dull.
The crisis should have cured us of the “pretence of knowledge” (Caballero 2010) – of the illusion that we understood problems of macroeconomic instability very well and had solved them all to general satisfaction. Once cured of this pretence – which is to say, once cognisant of our ignorance – we can see that macroeconomics poses a great many important questions to which my generation did not provide good answers. As Leijonhufvud concludes, that should make the subject full of intellectual excitement for those of you who are a few decades younger.
Caballero, Ricardo J (2010) “Macroeconomics After the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome,” NBER Working Paper 16429, October.
Leijonhufvud, Axel (2011). “Nature of an economy”, CEPR Policy Insight No 53, January.