Evening Must-Read: Frances Coppola: The Failure of Macroeconomics

…Olivier Blanchard, the IMF’s chief economist, recently wrote:

We in the field did think of the economy as roughly linear… fluctuating, but naturally returning to its steady state….

Blanchard went on to observe that… macroeconomists… [saw] extreme tail risk events… as a thing of the past in developed countries…. Central banks could prevent or stop market ‘panics’ by flooding the place with liquidity. If you get the policy settings right, linear models will work….

The financial crisis drew to our attention… finance…. No industry that can cause such havoc when it goes wrong should ever be regarded as irrelevant or superficial…. Yet macroeconomists regarded… financial institutions… as so unimportant that they could safely be ignored. Representative agent models, flawed though they are, at least attempt to explain the behaviour of households and firms: but the behaviour of banks, and things that don’t call themselves banks but do bank-like things, stayed under the radar… made it impossible for mainstream economists to understand the significance of the build-up of credit that led to the financial crisis. The warnings came principally from people outside mainstream economics, particularly the followers of Hyman Minsky….

The most influential people in macroeconomics have spent their lives developing theories and models that have been shown to be at best inadequate and at worst dangerously wrong. Olivier Blanchard’s call for policymakers to set policy in such a way that linear models will still work should be seen for what it is–the desperate cry of an aging economist who discovers that the foundations upon which he has built his career are made of sand. He is far from alone…. Macroeconomics has indeed failed… because of confirmation bias and selection bias among macroeconomists. Who would have thought it?