Can New Economic Thinking Solve the Next Crisis?

Can New Economic Thinking Solve the Next Crisis?

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Efforts such as Rethinking Economics and The Institute for New Economic Thinking are noteworthy attempts to, as INET says, “broaden and accelerate the development of new economic thinking that can lead to solutions for the great challenges of the 21st century. The havoc wrought by our recent global financial crisis has vividly demonstrated the deficiencies in our outdated current economic theories, and shown the need for new economic thinking – right now. 

It is certainly true that mainstream, modern macroeconomic models failed us prior to and during the Great Recession. The models failed to give any warning at all about the crisis that was about to hit – if anything those using modern macro models resisted the idea that a bubble was inflating in housing markets – and the models failed to give us the guidance we needed to implement effective monetary and fiscal policy responses to our economic problems. 

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But amid the calls for change in macroeconomics there is far too much attention on the tools and techniques that macroeconomists use to answer questions, and far too little attention on what really matters, the questions that economists ask.

There are good reasons to be critical of the rational expectations, dynamically optimizing, representative agent approach that underlies modern macroeconomic models. For example, the representative agent approach makes it difficult to study financial markets. At least two agents with different views about the future price of a financial asset are needed before we can even begin to model markets for financial assets, financial intermediation, and other key elements of the financial sector involved in financial meltdowns like the one we just experienced. 

So why did macroeconomists adopt a representative agent framework that made financial meltdowns so difficult to incorporate into their models? Part of the answer is that there are technical difficulties with dropping the representative agent approach and having more than one agent in these models. It is difficult, if not impossible, to aggregate across individuals and obtain a tractable, stable model with desirable properties.

It was, importantly, also because macroeconomists, for the most part, did not think questions about financial meltdowns were worth asking, so why bother with those theoretical complications? The financial collapse problem had been overcome, or so some macroeconomists thought. 

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Nobel prize winning economist Robert Lucas, for example, in his 2003 presidential address to the American Economic Association famously claimed that the “central problem of depression-prevention has been solved.” In fact, to those in control of the journals and other outlets for professional research, these questions were more than uninteresting, asking them would risk professional ridicule. Lucas also said of Keynesian economics, which was built to answer exactly the kinds of questions we confronted during the Great recession, "At research seminars, people don’t take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another." 

The questions that macroeconomists ask are dictated, in large part, by current macroeconomic events. The ridicule directed at those involved in “Keynesian” research programs has faded in light of the great Recession. Questions about how deep, prolonged recessions occur, how they can be prevented, and what polices we should pursue if these problems emerge, are back at the forefront.

That is a good thing. We ought to be involved in important debates over economic issues. During the Great Moderation that preceded the financial meltdown, for example, we should have been actively engaged in trying to understand why fluctuations in the economy had all but disappeared.

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That doesn’t mean that other questions are uninteresting and have no place in our professional discourse. Just because a question is not of immediate concern does not mean it will never arise. That should be one of the lessons for those who thought that “depression-prevention has been solved” once and for all.

Presently, for example, questions about the international flow of financial assets and the balance of trade have all but disappeared from the economics discourse. Prior to the financial crisis these questions were more prominent, e.g. the literature on the savings glut, and there was a time when new data on the balance of trade received almost as much attention as the unemployment rate. But those questions have faded. Does that mean such questions will never be important and research into these topics should be dismissed as uninteresting?

There has been quite a bit of criticism directed at the tools and techniques that macroeconomists use, e.g. criticism of dynamic stochastic general equilibrium (DSGE) models, but that criticism is misplaced. The tools and techniques that macroeconomists use are developed to answer specific questions. If we ask the right questions, then we will find the tools and techniques needed to answer them.

The problem with macroeconomics is not that it has become overly mathematical – it is not the tools and techniques we use to answer questions. The problem is the sociology within the economics profession that prevents some questions from being asked. Why, for example, were the very questions we needed to ask prior to the Great Recession ridiculed by important voices within the profession? 

The key to a better economics is to ask better questions, and that will require a much more open mind – particularly from those in charge of what gets published in economic journals – about the kinds of questions economists are allowed to ask.

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