Modern macroeconomics - like Hamlet without the Prince

7 January, 2013 at 15:37 | Posted in Economics | 1 Comment

In yesterday’s Wall Street Journal, Simon Nixon had an insightful article on the miserable state of modern macroeconomics. What he says should come as no surprise – at least not for those of you who regularly follow yours truly’s blog.

Forecasting is by its nature a hit-and-miss affair; economics is not—despite the apparent dogmatic certainty of some of its practitioners—an exact science. But the track record of the profession in recent years—and last year in particular —is dire. Few economists spotted the boom and most hopelessly underestimated the bust. And it’s not as if the profession’s troubles in 2012 were limited to longer-range forecasts; it was getting it wrong virtually in real time with most forecasters forced to slash their projections every few months as each quarter turned out worse than expected …

What the dismal science’s dismal record suggests is that there is something profoundly wrong with the mainstream economics profession’s understanding of how modern economies work. The models on which its forecasts are built are clearly badly flawed …

But the most important contribution to the debate is an essay by Claudio Borio, deputy head of the monetary and economics department at the Bank for International Settlements, published last moth and titled: “The Financial Cycle and Macroeconomics: What have we learned?”

In Mr. Borio’s view, the “New Keynesian Dynamic Stochastic General Equilibrium” model used by most mainstream forecasters is flawed because it assumes the financial system is frictionless: Its role is simply to allocate resources and therefore can be ignored. Although many economists now accept these assumptions are wrong, efforts to modify their models amount to little more than tinkering. What is needed is a return to out-of-fashion insights influential before World War II and kept alive since by maverick economists such as Hyman Minsky and Charles Kindleberger that recognized the central importance of the financial cycle.

Mainstream economists have been so fixated on understanding ordinary business cycles that they ignored the role that years of rising asset prices and financial sector liberalization can play in fueling credit booms. They lost sight of the fact that the financial system does more than allocate resources: It creates money—and therefore purchasing power—every time it extends a loan.

“Macroeconomics without the financial cycle is like Hamlet without the Prince,” to Mr. Borio.

Simon Nixon

About these ads