Modern macroeconomics — totally messed up

17 August, 2017 at 16:39 | Posted in Economics | 3 Comments

Until a few years ago, economists of all persuasions confidently proclaimed that the Great Depression would never recur. In a way, they were right. After the financial crisis of 2008 erupted, we got the Great Recession instead. Governments managed to limit the damage by pumping huge amounts of money into the global economy and slashing interest rates to near zero. But, having cut off the downward slide of 2008-2009, they ran out of intellectual and political ammunition.


Economic advisers assured their bosses that recovery would be rapid. And there was some revival; but then it stalled in 2010. Meanwhile, governments were running large deficits – a legacy of the economic downturn – which renewed growth was supposed to shrink. In the eurozone, countries like Greece faced sovereign-debt crises as bank bailouts turned private debt into public debt.

Attention switched to the problem of fiscal deficits and the relationship between deficits and economic growth. Should governments deliberately expand their deficits to offset the fall in household and investment demand? Or should they try to cut public spending in order to free up money for private spending?

Depending on which macroeconomic theory one held, both could be presented as pro-growth policies. The first might cause the economy to expand, because the government was increasing public spending; the second, because they were cutting it. Keynesian theory suggests the first; governments unanimously put their faith in the second.

The consequences of this choice are clear. It is now pretty much agreed that fiscal tightening has cost developed economies 5-10 percentage points of GDP growth since 2010. All of that output and income has been permanently lost. Moreover, because fiscal austerity stifled economic growth, it made the task of reducing budget deficits and national debt as a share of GDP much more difficult. Cutting public spending, it turned out, was not the same as cutting the deficit, because it cut the economy at the same time.

Robert Skidelsky

Indeed, there are many kinds of useless economics held in high regard within the mainstream economics establishment today. Few are less deserved than the post-real macroeconomic theory — mostly connected with Finn Kydland, Robert Lucas, Edward Prescott and Thomas Sargent — called Real Business Cycle theory (RBC).

In Chicago economics, one is cultivating the view that scientific theories have nothing to do with truth. Constructing theories and building models is not even considered an activity with the intent of approximating truth. For Chicago economists, it is only an endeavour to organize their thoughts in a ‘useful’ manner.

What a handy view of science!

What these defenders of scientific storytelling ‘forget’ is that potential explanatory power achieved in thought experimental models is not enough for attaining real explanations. Model explanations are at best conjectures, and whether they do or do not explain things in the real world is something we have to test. To just believe that you understand or explain things better with thought experiments is not enough.

Without a warranted export certificate to the real world, model explanations are pretty worthless. Proving things in models is not enough — not even after having put ‘New Keynesian’ sticky-price DSGE lipstick on the RBC pig.

Truth is an important concept in real science — and models based on meaningless calibrated ‘facts’ and ‘assumptions’ with unknown truth value are poor substitutes.



  1. Except austerity in Europe didn’t happen. Politicans may have claimed they were reducing the economic deficit but the abundance of automatic stabilizers in European economies ensured that fiscal policies were expansive.
    Got any evidence to show Europe was actually using an austerity policy?

    • Greece? The IMF and ECB were in control of Greece’s fiscal policy and reduced pensions, as well as privatizing airports and the like. Many in Greece suffered as a result. See “Study reveals austerity’s harmful impact on health in Greece”

      • I wanted to add (my first attempt at posting was lost) that the ECB benefitted from an unlimited currency swap line with the Fed in 2008 and after. When the ECB and German and Swiss banks were in crisis, the ECB could get as many US Dollars as it asked for from the Fed (see The ECB could then pass those US dollars on to Deutsche Bank, etc. There was no capacity limit on the swap line and no rollover risk.

        Why couldn’t the ECB extend the same courtesy to Greece in its time of crisis, as the Fed extended to the ECB when the EU was in crisis? It is funny that the EU is so quick to overturn the Shengen Agreement but so stingy about contravening the Maastricht Treaty.

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