Stiglitz on the need for a new economic paradigm

The standard macroeconomic models have failed, by all the most important tests of scientific theory. They did not predict that the financial crisis would happen; and when it did, they understated its effects. Monetary authorities allowed bubbles to grow and focused on keeping inflation low, partly because the standard models suggested that low inflation was necessary and almost sufficient for efficiency and growth. After the crisis broke, policymakers relying on the models floundered. Notwithstanding the diversity of macroeconomics, the sum of these failures points to the need for a fundamental re-examination of the models—and a reassertion of the lessons of modern general equilibrium theory that were seemingly forgotten in the years leading up to the crisis.

See the Stigliz contribution in the Financial Times web site.

Lucas in Defence of the Dismal Science

One thing we are not going to have, now or ever, is a set of models that forecasts sudden falls in the value of financial assets, like the declines that followed the failure of Lehman Brothers in September. This is nothing new. It has been known for more than 40 years and is one of the main implications of Eugene Fama’s “efficient-market hypothesis” (EMH), which states that the price of a financial asset reflects all relevant, generally available information. If an economist had a formula that could reliably forecast crises a week in advance, say, then that formula would become part of generally available information and prices would fall a week earlier. (The term “efficient” as used here means that individuals use information in their own private interest. It has nothing to do with socially desirable pricing; people often confuse the two.)

The Economist’s briefing also cited as an example of macroeconomic failure the “reassuring” simulations that Frederic Mishkin, then a governor of the Federal Reserve, presented in the summer of 2007. The charge is that the Fed’s FRB/US forecasting model failed to predict the events of September 2008. Yet the simulations were not presented as assurance that no crisis would occur, but as a forecast of what could be expected conditional on a crisis not occurring. Until the Lehman failure the recession was pretty typical of the modest downturns of the post-war period. There was a recession under way, led by the decline in housing construction. Mr Mishkin’s forecast was a reasonable estimate of what would have followed if the housing decline had continued to be the only or the main factor involved in the economic downturn. After the Lehman bankruptcy, too, models very like the one Mr Mishkin had used, combined with new information, gave what turned out to be very accurate estimates of the private-spending reductions that ensued over the next two quarters. When Ben Bernanke, the chairman of the Fed, warned Hank Paulson, the then treasury secretary, of the economic danger facing America immediately after Lehman’s failure, he knew what he was talking about.

Mr Mishkin recognised the potential for a financial crisis in 2007, of course. Mr Bernanke certainly did as well. But recommending pre-emptive monetary policies on the scale of the policies that were applied later on would have been like turning abruptly off the road because of the potential for someone suddenly to swerve head-on into your lane. The best and only realistic thing you can do in this context is to keep your eyes open and hope for the best.

For the full Lucas contribution see The Economist web page

Marshall on The Ordinary Business of Life

"Political Economy or Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of well being." Alfred Marshall, Principles of Economics, 1890.