Last week (December 10, 2012), the Bank of International Settlements released a working paper – The financial cycle and macroeconomics: What have we learnt? – which not only recognised that the accepted mainstream macroeconomic theory is critically deficient but also implied that the response to that failure in the context of the global financial crisis is not likely to be satisfactory. Faced with a major credibility crisis at the onset of the GFC, there has been a mad rush by mainstream economists to add financial sector to their models. It might surprise you that the major models used to teach students and motivate research in macroeconomics didn’t even have financial sectors included, among other glaring deficiencies. Now there is a flurry of work to address that deficiency. The problem is that all this effort, which will produce countless papers at academic conferences, will not address the fundamental issue – the mainstream macroeconomics framework is rotten to the core. The BIS paper provides some insights into that issue. When it comes down to the fundamental question: What have we learn’t? If the we is referring to the dominant body of macroeconomists that teach in universities, publish research in the journals and occupy key positions in policy-making bureaucracies, then the answer is simple: Nothing! (thanks Roger). But we have also learn’t that Modern Monetary Theory (MMT) has demonstrated itself to be a credible framework.
The BIS paper embraces various technical arguments, which are not suitable for the general audience that reads my blog. But there are easily understood arguments that are, which are of relevance to Modern Monetary Theory (MMT).
At the outset, the BIS paper recognises that:
The notion of the financial cycle, and its role in macroeconomics … actually predates the much more common and influential one of the business cycle … But for most of the postwar period it fell out of favour. It featured, more or less prominently, only in the accounts of economists outside the mainstream … [Minsky and Kindleberger cited] … Indeed, financial factors in general progressively disappeared from macroeconomists’ radar screen. Finance came to be seen effectively as a veil – a factor that, as a first approximation, could be ignored when seeking to understand business fluctuations …
What a difference a few years can make! The financial crisis that engulfed mature economies in the late 2000s has prompted much soul searching. Economists are now trying hard to incorporate financial factors into standard macroeconomic models. However, the prevailing, in fact almost exclusive, strategy is a conservative one. It is to graft additional so-called financial “frictions” on otherwise fully well behaved equilibrium macroeconomic models, built on real-business-cycle foundations and augmented with nominal rigidities. The approach is firmly anchored in the New Keynesian Dynamic Stochastic General Equilibrium (DSGE) paradigm.
This is a very important observation for two reasons. First, MMT insights have always been grounded in the importance of understanding financial cycles from the start. In the words of the BIS paper, MMT has recognised “fully the fundamental monetary nature of our economies”.
Second, the conservative or mainstream response (which still forms the dominant paradigm in macroeconomics) has not learned much at all. They haven’t realised that their comfort blankets, aka New Keynesian DSGE models cannot be modified to “incorporate financial factors” in any way that will produce meaningful insights. The problem is that the core is rotten and has to be abandoned.
While the BIS paper is circumspect in that regard, presumably because the majority of the author’s BIS colleagues are wedded to the conservative approach, it is clear that he doesn’t think the “conservative” approach will cut the mustard.
In this blog – Mainstream macroeconomic fads – just a waste of time – I considered so-called New Keynesian models of the macroeconomy which dominate the mainstream of my profession.
The New Keynesian approach has provided the basis for a new consensus emerging among orthodox macroeconomists. It attempted to merge the so-called Keynesian elements of money, imperfect competition and rigid prices with the real business cycle theory elements of rational expectations, market clearing and optimisation across time, all within a stochastic dynamic model.
New Keynesian theory is actually very easy to understand despite the deliberate complexity of the mathematical techniques that are typically employed by its practitioners. In other words, like most of the advanced macroeconomics theory it looks to be complex and that perception serves the ideological agenda – to avoid scrutiny but appear authoritative.
Graduate students who undertake advanced macroeconomics become imbued with their own self-importance as they churn out what they think is deep theory that only the cognoscenti can embrace – the rest – stupid (doing Arts or Law or something). If only they knew they were reciting garbage and had, in fact, very little to say (in a meaningful sense) about the topics they claim intellectual superiority.
The professors who taught them are worse, if that is possible.
By way of background, Dynamic stochastic general equilibrium (DSGE) models are now the dominant modelling structures used by mainstream macroeconomists. They are tangential to meaning.
Even mainstreamers like Willem Buiter described DSGE modelling as “The unfortunate uselessness of most ‘state of the art’ academic monetary economics”. He noted that:
Most mainstream macroeconomic theoretical innovations since the 1970s (the New Classical rational expectations revolution … and the New Keynesian theorizing … have turned out to be self-referential, inward-looking distractions at best. Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes rather than by a powerful desire to understand how the economy works – let alone how the economy works during times of stress and financial instability. So the economics profession was caught unprepared when the crisis struck … the Dynamic Stochastic General Equilibrium approach which for a while was the staple of central banks’ internal modelling … excludes everything relevant to the pursuit of financial stability.
This conclusion was made with some style in evidence that famous (pre-DSGE) economist Robert Solow gave to the US Congress Committee on Science, Space and Technology – in its sub-committee hearings on Investigations and Oversight Hearing – Science of Economics on Jul 20, 2010. The evidence is available HERE.
Here is an excerpt relevant to the topic:
Under pressure from skeptics and from the need to deal with actual data, DSGE modellers have worked hard to allow for various market frictions and imperfections like rigid prices and wages, asymmetries of information, time lags, and so on. This is all to the good. But the basic story always treats the whole economy as if it were like a person, trying consciously and rationally to do the best it can on behalf of the representative agent, given its circumstances. This can not be an adequate description of a national economy, which is pretty conspicuously not pursuing a consistent goal. A thoughtful person, faced with the thought that economic policy was being pursued on this basis, might reasonably wonder what planet he or she is on.
An obvious example is that the DSGE story has no real room for unemployment of the kind we see most of the time, and especially now: unemployment that is pure waste. There are competent workers, willing to work at the prevailing wage or even a bit less, but the potential job is stymied by a market failure. The economy is unable to organize a win-win situation that is apparently there for the taking. This sort of outcome is incompatible with the notion that the economy is in rational pursuit of an intelligible goal. The only way that DSGE and related models can cope with unemployment is to make it somehow voluntary, a choice of current leisure or a desire to retain some kind of flexibility for the future or something like that. But this is exactly the sort of explanation that does not pass the smell test.
Solow also said that the DSGE fraternity “has nothing useful to say about anti-recession policy because it has built into its essentially implausible assumptions the “conclusion” that there is nothing for macroeconomic policy to do”.
None of the DSGE models (or papers) anticipated the financial crisis despite the portents of it being obvious for at least a decade or more.
In my 2008 book (with Joan Muysken) – Full Employment abandoned – we considered the standard DSGE approach in detail. I summarised a bit of that discussion in this blog – Mainstream macroeconomic fads – just a waste of time.
The alleged advantage of the New Keynesian approach (which incorporates DSGE modelling) is the integration of real business cycle theory elements (intertemporal optimisation, rational expectations, and market clearing) into a stochastic dynamic macroeconomic model. The problem is that the abstract theory does not relate to the empirical world. To then get some traction (as Solow noted) with data, the “theoretical rigour” is supplanted by a series of ad hoc additions which effectively undermine the claim to theoretical rigour.
You cannot have it both ways. These economists first try to garner credibility by appealing to the theoretical rigour of their models. But then, confronted with the fact that these models have nothing to say about the real world, the same economists compromise that rigour to introduce structures (and variables) that can relate to the real world data. But they never let on that the authority of this compromise is lost although the authority was only ever in the terms that this lot think. No reasonable assessment would associate intellectual authority (knowledge generation) with the theoretical rigour that we see in these models.
This is the fundamental weakness of the New Keynesian approach. The mathematical solution of the dynamic stochastic models as required by the rational expectations approach forces a highly simplified specification in terms of the underlying behavioural assumptions deployed. As Solow says this simplicity cannot remotely relate to the real world.
Further, the empirical credibility of the abstract DSGE models is highly questionable. There is a substantial literature pointing out that the models do not stack up against the data.
Clearly, the claimed theoretical robustness of the DSGE models has to give way to empirical fixes, which leave the econometric equations indistinguishable from other competing theoretical approaches where inertia is considered important. And then the initial authority of the rigour is gone anyway.
This general ad hoc approach to empirical anomaly cripples the DSGE models and strains their credibility. When confronted with increasing empirical failures, proponents of DSGE models have implemented these ad hoc amendments to the specifications to make them more realistic. I could provide countless examples which include studies of habit formation in consumption behaviour; contrived variations to investment behaviour such as time-to-build , capital adjustment costs or credit rationing.
But the worst examples are those that attempt to explain unemployment. Various authors introduce labour market dynamics and pay specific attention to the wage setting process. One should not be seduced by DSGE models that include real world concessions such as labour market frictions and wage rigidities in their analysis. Their focus is predominantly on the determinants of inflation with unemployment hardly being discussed.
Of-course, the point that the DSGE authors appear unable to grasp is that these ad hoc additions, which aim to fill the gaping empirical cracks in their models, also compromise the underlying rigour provided by the assumptions of intertemporal optimisation and rational expectations.
And as the BIS paper points out the mainstream macroeconomists are at it again. This time they are attempting to become relevant in the face of their disastrous lack of awareness that a major financial crisis was approaching.
The BIS paper lists five “stylised facts” of the financial cycle which present the mainstream macroeconomics models with problems. I don’t have time to provide a detailed discussion of these “facts” but in the next discussion you will pick up the important issues.
One interesting observation is that the “length and amplitude of the financial cycle”, which the BIS identify as being longer and of larger than the real GDP cycle, is dependent on “the policy regimes in place”.
The point the paper makes is that:
Financial liberalisation weakens financing constraints, supporting the full self-reinforcing interplay between perceptions of value and risk, risk attitudes and funding conditions. A monetary policy regime narrowly focused on controlling near-term inflation removes the need to tighten policy when financial booms take hold against the backdrop of low and stable inflation. And major positive supply side developments, such as those associated with the globalisation of the real side of the economy, provide plenty of fuel for financial booms: they raise growth potential and hence the scope for credit and asset price booms while at the same time putting downward pressure on inflation, thereby constraining the room for monetary policy tightening.
In other words, the dominant macroeconomic policy tool under neo-liberalism – monetary policy – is not capable of responding to the underlying financial cycle pressures that build relentlessly as credit growth expands. The mainstream textbooks still teach students that the central bank can control the money supply and thus head off these problems.
That is plain wrong.
The problem is that monetary policy has been promoted as the primary counter-stabilising policy tool because of the ideological hatred held by the mainstream macroeconomists towards the use of fiscal policy. The sophistry that that been developed to promote the idea that monetary policy is superior and that fiscal policy should be a passive player (biased towards surpluses) is not evidence-based. It in fact, runs counter to the evidence.
The current crisis has taught us that fiscal policy is very effective in both directions – saving the World from Depression when stimulus was applied but driving the economies back towards that state when fiscal austerity was introduced.
The fact that there have been near-zero interest rates in most nations for the last four years with not end in sight and multiple bouts of so-called quantitative easing, yet the World is struggling to exit its recessed state also demonstrates the relative ineffectiveness of monetary policy.
The BIS paper is clear – after examining the way financial cycles unfold – that:
… it is quite possible for inflation to remain stable while output is on an unsustainable path, owing to the build-up of financial imbalances and the distortions they mask in the real economy. Ostensibly, sustainable output and non-inflationary output need not coincide.
I intend to address this particular point in a separate blog because it has significant importance for the way we measure real output gaps. The BIS paper thinks that it biases us towards thinking there are larger output gaps than there are in reality. I disagree with that but it is a separate topic.
The BIS paper also notes that the amplitude of financial cycles has increased since the mid-1990s, as neo-liberalism (my term) has pressured governments to deregulate financial markets.
Importantly, the BIS say that the “(p)eaks in the financial cycle are closely associated with systemic banking crises”.
This leads to the conclusion, which is totally consistent with the main body of Modern Monetary Theory (MMT) that financial booms do “not just precede the bust but cause it”. In MMT, we trace these financial booms to the interaction between government policy and the non-government sector credit dynamics. A focus on the latter, which many Post-Keynesians provide, is insufficient. To introduce money into the system one has to understand the basic government-non-government relationship.
One cannot gain a full understanding by developing complex, non-linear models or otherwise of the non-government sector as a standalone exercise.
So it was of-course impossible for the main advanced macroeconomics textbook models preached by majority of my profession to see the crisis coming because they had no explicit recognition of the financial cycle.
In MMT, apart from the explicit Minksyian analysis, the broad sectoral balances framework integrates the financial and real economy in a stock-flow consistent manner. Please read my blogs – Sectoral balances – Part 1 and Sectoral balances – Part 2 and Sectoral balances – Part 3.
Further, please read my blog – Stock-flow consistent macro models – for more discussion on this point.
The BIS paper tells us that the mainstream response to this deficiency is also likely to be deficient. My words would have been will “certainly” be deficient. But style is context dependent after all.
The paper says that the idea that financial cycles cause crises:
… is harder to reconcile with today’s dominant view of business fluctuations … which sees them as the result of random exogenous shocks transmitted to the economy by propagation mechanisms inherent in the economic structure … And it is especially hard to reconcile with the approaches grafted on the real-business-cycle tradition, in which in the absence of persistent shocks the economy rapidly returns to steady state.
The BIS paper then turned to how macroeconomists should best respond to the current failure of their (mainstream) models. It urges us to “move away from model-consistent (“rational”) expectations”, which produce “artificial” understandings.
It urges us to incorporate endogenous risk tolerances – that is, “attitudes towards risk that vary with the state of the economy, wealth and balance sheets” – which is really a central idea in the work of Minsky and Kindleberger. MMT is totally consistent with those insights.
Most importantly, the BIS paper urges us to take a “more fundamental, step” and that is:
… to capture more deeply the monetary nature of our economies … models should deal with true monetary economies, not with real economies treated as monetary ones … Financial contracts are set in nominal, not in real, terms. More importantly, the banking system does not simply transfer real resources, more or less efficiently, from one sector to another; it generates (nominal) purchasing power. Deposits are not endowments that precede loan formation; it is loans that create deposits. Money is not a “friction” but a necessary ingredient that improves over barter. And while the generation of purchasing power acts as oil for the economic machine, it can, in the process, open the door to instability, when combined with some of the previous elements. Working with better representations of monetary economies should help cast further light on the aggregate and sectoral distortions that arise in the real economy when credit creation becomes unanchored, poorly pinned down by loose perceptions of value and risks … move away from the heavy focus on equilibrium concepts and methods to analyse business fluctuations and to rediscover the merits of disequilibrium analysis …
While the BIS paper would not explicitly mention MMT, regular readers will identify standard MMT constructs in the previously quoted paragraph.
You will see that it eschews the mainstream analysis of banking, which relies on the money multiplier to link the central bank to the money supply and constructs private banks as being deposit-taking institutions, which then on-lend those deposits in ways that conform to the resource allocation patterns determined by profit-maximising, market-driven, optimising private agents.
Nothing, of-course, could be further from the truth. Deposits do not “create” loans. Loans create deposits. The money supply is endogenously driven by the credit demand from the private sector, who have no claim to being rational and optimising. The GFC has dispelled that myth – as previous crises have dispelled it in the past. It is just that, in the words of the BIS paper, “(s)o-called ‘lessons’ are learnt, forgotten, re-learnt and forgotten again.”
I would have said the so-called “lessons” are denied by an ideological arrogance that is intent on defending the hegemony of the paradigm and the rewards that delivers the main players rather than advancing any notion of knowledge or insight.
The BIS paper then moved onto how to deal with the financial bust and provided a discussion of fiscal policy but I have run out of time today. I will return to that theme later in the week.
But the point is clear – there is no hope for the mainstream approach. It is just iterating on a rotten core. The problem then is that by retaining the dominant position in the policy debate, the mainstream macroeconomists are perverting the policy response to the crisis and millions are unemployed and being driven in to poverty than would be the case if there was a more effective policy intervention, focused on restoring currency sovereignty where it had been surrendered and implementing employment-rich, fiscal stimulus.
That is enough for today!
(c) Copyright 2012 Bill Mitchell. All Rights Reserved.