Why was the financial crisis of 2008 so surprising to so many macroeconomists (but from my experience, a little less so for international finance economists familiar with financial crises in emerging markets…)? From the conclusion to George Akerlof’s “What They Were Thinking Then: The Consequences for Macroeconomics during the Past 60 Years” in the latest JEP.
The adaptation of The General Theory into the Keynesian-neoclassical synthesis neglected multiple vulnerabilities of the resultant model. Of course, there were reasons for this adaptation, prominently including a desire to build a professional consensus in support of activist Keynesian fiscal policy. By creating a model with an aggregate supply side that was classical in nature, and that allowed plentiful opportunities for economists to practice one-deviation-at-a-time analysis, support was indeed bolstered for Keynesian policy. But Keynesian economists became overly attached to their paradigm. They were dismissive of anomalous observations that indicated the need for new, more nuanced economic thinking.
The Keynesian-neoclassical synthesis that had emerged by the early 1960s put constraints on macroeconomics. Foremost, it divorced macroeconomists from working on financial stability. Luckily, after the crash of 2008, the prior work of finance economists has been belatedly acknowledged, and the subfield of macro stability has also emerged as quite possibly the most vibrant research frontier in economics. Nevertheless, macroprudential concerns remain as back matter in the textbooks. Correspondingly, macroprudential policy is undervalued in the councils of government. Yet its importance remains, given the likelihood of another crash. Inthese consequential ways, macroeconomists’ dismissal of “satiric entertainment” in the decades after The General Theory still lives with us. …
The assumption that “the plumbing” would work was a little less pervasive amongst economists trying to delve into why emerging market economies periodically experienced financial crises — think Thailand and Korea, and the revelatory balance sheet induced recessions of the 1990’s. What was surprising was that the valuation and contingent liability issues so pervasive in emerging markets could also arise in the US.
Some retrospective discussion in Chinn and Frieden, and prospective discussion in Chinn (Council on Foreign Relations, 2005).
Excellent piece by George. Only problem is that he leaves out some of the more heterodox schools of thought such as Post Keynseian, MMT, and Austrian. But his account of the mainline developments and some non-mainstream variatinos, especially his old fave, behavioral, is top notch and an insider perspective.
BTW, at ASSA he spoke on Paul Romer during the Nobel Prize luncheon, the only speaker who was also a Nobelist. His wife, Janet Yellen, now AEA president, was chairing the session. I had not realized how many papers he coauthored with Romer, and, of course, that was also a fine talk.
I’ll admit that I got lucky before 2008. Everything was looking great. The markets were up; home prices were up, employment was good. A lot like now. But I noticed rumblings out of the Fed on the prime rate. I watched it going up in ’04, but didn’t do anything with my investments. I watched it continue to go up in ’05 and got nervous, and when it hit 7% I just cashed out and went into a principle guaranteed 5% money market fund. Then I questioned my decision for awhile as the markets and housing continued to look good; was I too pessimistic? But when the Fed started to reverse itself, I felt more comfortable with my decision because that signalled to me that all was not well.
So, I got lucky. No macroeconomics theory; just a bad feeling about the way things were.
I suppose we could draw some parallels to that period with what is going on now. But the Fed has pretty much taken itself out of the “steering the economy” role. Inflation and interest rates are low, economic growth is moderate, housing is affordable (except for a few locations), employment is great. So why am I getting an uneasy feeling again? Perhaps it’s because of what I am hearing from some of the potential candidates for POTUS.
So it is all about Bruce Hall and nothing else? Or did you just not understand what this paper was about? Go figure!
Single statistic Bruce “no relationship to Robert” Hall has said some incredibly stupid things here but this one really takes the cake!
“But I noticed rumblings out of the Fed on the prime rate. I watched it going up in ’04, but didn’t do anything with my investments. I watched it continue to go up in ’05 and got nervous, and when it hit 7%”
Actually the prime rate went from 4% to 8.25% but I guess Brucie did not notice that this was only following what was going on with the 3-month Treasury bill, which rose from 1% to 5% during the same period. This has NOTHING to do with the financial fragility issue discussed in this ASSA paper. Nothing at all. But it is all about Bruce so hey!
“Perhaps it’s because of what I am hearing from some of the potential candidates for POTUS.”
i assume you are referring to the possibility that an impeached president could once again be a candidate for office? that would have far more influence on your uneasy feeling, unless you actually believe trump will no longer be in office (for whatever reason)? that would be the only way those other potential candidates could generate your “uneasy” feeling. personally, i believe your statement to be nothing more than a political hack comment.
More interesting reading while we breathe in smoke here.
Thanks Menzie
‘But in chapter 12 of The General Theory, on “the state of long-term expectation,” Keynes (1936) had suggested a very different analysis of boom and bust: those bad times result largely from financial fragility … In a bank run model (like that of Diamond and Dybvig 1983)’
I’ve taken a small slice of this excellent discussion only to note that this line of thinking was in Milton Friedman’s explanation for the Great Depression as well as 1963. Ben Bernanke recognized that and started incorporating things like corporate bond spreads into his macroeconomics. The BBB credit spread spiked in the early 1930’s and then spiked again during the 2007 to 2009 period. We saw a small tidal wave in the early 1980’s with the S&L crisis but the Great Recession was accompanied by a tsunami.
You should note that quality spreads move in lock-step with capacity utilization.
“But Samuelson alerted the class to a potential problem with this conventional wisdom. Maybe, he said—just maybe—with high levels of employment, inflationary wage and price changes that would occur would feed back into higher inflationary expectations. And, if those higher expectations themselves were added onto the wage (and price) changes, inflation would accelerate. Thus, the trade-off would not be between unemployment and a constant level of inflation; it would be between unemployment and the acceleration of inflation”
And yet we give credit to Friedman and Phelps for this insight. A lot of right wing hacks claim that Keynesians like Samuelson did not understand this. The truth is that the Keynesian CEA were warning President Johnson that fiscal policy had turned too expansionary with the triple whammy of the 1964 tax cut, the Great Society programs, and the Vietnam defense spending build-up. Since Johnson was not going to reverse the increases in government spending, they suggested an increase in taxes. Who objected? Supply-siders dismissed the CEA concerns. They were wrong but they are too dishonest to admit it. No – these hacks blame the Keynesians instead.
Menzie, the methodology of macro from the late 80s on did not involve allowing for sharp breaks in the macro data. No driving over a cliff-type stuff. At the IMF and in IFM we’ve been messing with just such experiences. Salant and Henderson freed us up to think….and there’s been a LOT of papers.
bob flood: Agree – those of us in international finance (and people like you) were more aware of the implications of sharp changes in DGP switches and/or expectations switches than our developed country macro brethren (at least that’s my opinion). Well, I was never invited into EF&G…
I wonder if research opportunities may be fruitful in many academic subjects when a complex concept is thought to be settled as exemplified below from the Akerlof article.
1. “… [O]ne-deviation-at-a-time constraints have had real consequences for macroeconomics. For example, they resulted in the omission of plausible models with very different core conclusions regarding the effectiveness of macro stabilization.”
2. “The great public policy question of the day—how to fight underemployment—had…been solved.”
3. “For MIT graduate students at this time, the state of macroeconomics conveyed to us was that the issue of macro stabilization had been resolved.”
4. “It was further understood among us graduate students that the ongoing research in business cycle macroeconomics was beyond our pay grade.”
5. “… [P]roclamations of the end of macroeconomics were premature.”
Perhaps it is dangerous to think that a complex subject is settled. Below are a couple examples from the physical sciences.
a. At one time the concept may have been considered to be settled when the earth was thought to be the center of the universe.
b. At one time light was thought to travel through either and was perhaps thought to be settled science by some researchers https://en.wikipedia.org/wiki/Luminiferous_aether
An accounting example to settle how to record certain financial investments is shown below:
Prior to the Great Recession, accounting rules changed to require mark-to-market recording for certain financial obligations. This change from allowing recording at book value was thought to be “better” accounting to represent reality. This new requirement seemed to add to the financial chaos.
for those who understand the repo market and recent conditions, perhaps you could explain something to me. my understanding is this market is essentially very short duration loans (daily or weekly) which are supposed to be paid back in full with interest. otherwise the collateral is turned over. so the net effect of this effort should be little increase in the fed balance sheet over time. yet from what i understand, the fed balance sheet is increasing due to this repo action? so my question is related to this increase. is this a result of parties not paying back their loan, or simply an accumulation faster than payoffs, which will eventually drop to previous levels? and if the fed is accumulating due to defaults, is there any description of the quality of assets it is collecting in those defaults? is there something unique about those assets (interest too low, poor quality, etc)? why are what appear to be short term actions (repo) staying on the books in a more permanent manner? it is this duration aspect that i do not understand.