All lucky breaks come to an end: the shortcomings of macroeconomic models following the financial crisis and the contribution of behavioural economics to the reconfiguration of macroeconomics
The 2007 subprime crisis continues to generate a large literature, although a consensus is emerging on what factors caused it. Namely: inadequate regulation of ﬁnancial institutions and instruments; problems connected with the securitisation of disparate revenue streams to create ever riskier ﬁnancial instruments; the inadequate credit ratings of the various tranches by the three major credit rating agencies where there was a conﬂict of interests (ratings were purchased by the originators of the instruments and not the investors); principal-agent problems in the banking system leading to excessive risk taking in the context of low interest rates; moral hazard (the belief that banks were ‘too big to fail’); contagion effects in Europe and elsewhere; global imbalances attributable to surpluses in China, the Middle Eastern economies and Japan; and the failure of monetary policy that kept interest rates too low and for too long. To this must be added the amplifying effects of the large increase in leverage of the banks that had occurred over the previous two decades (see, for example, Blanchard, 2009; Brunnermeier, 2009; Rajan, 2005, 2010; Roubini and Mihm, 2010). Consequently the crisis per se is not examined in any depth, rather the focus of this chapter is on the failure of macroeconomic theory and in particular the rational expectations hypothesis (REH) and the efﬁcient markets hypothesis (EMH). The subprime crisis exposed more than any formal testing could have done the deﬁciencies in the New Classical macroeconomic paradigm while a jaundiced view of the usefulness of econometrics in altering any economist’s weltanschauung can be found in Summers (1991). An uneasy truce had emerged after the acrimonious debates of the 1980s between the Neo-Keynesians and the New Classical economists over the REH and the assumption of market clearing. The New Neoclassical Synthesis emerged based essentially on the New Classical approach, except that it incorporated rational expectations and sticky prices from Neo-Keynesian economics. This, in
the view of Goodfriend (2004, 2007) amongst others, supposedly gave macroeconomics sound microfoundations. Apart from some mainstream dissenters like Solow (2008) most macroeconomists outside the post-Keynesian group supported this synthesis. The fragile truce ended, however, with the subprime crisis as the lucky break of the past came to an end. For example, Blanchﬂower (2009), then a member of the UK’s Monetary Policy Committee, dismissed macroeconomic theory as useless in understanding the crisis and providing an appropriate policy response. Buiter (2009), another former member of the Committee concurred. The fundamental foundations of received macroeconomics were questioned by Krugman (2009) and Cochrane (2009) indicating growing divisions over the veracity of the model. In this chapter, ﬁrst the development of the New Neoclassical Synthesis (NNS) and the New Macroeconomics Consensus (NMC) based on the former synthesis are examined (the NMC refers to the applied studies and policy implications, most notably inﬂation targeting). The shortcomings of this approach are then considered in the light of the subprime crisis. In particular, one of the major shortcomings of the NNS, namely that individuals and institutions act in the presence of Knightian uncertainty (in a non-ergodic world) rather than, as assumed by the NNS, being faced by risk given by a well-deﬁned probability distribution. The conclusions look at the methodological way forward, with a discussion of some aspects of behavioural economics and behavioural ﬁnance.