Should-Read: Martin Wolf: Economics failed us before the global crisis

Should-Read: Martin Wolf: Economics failed us before the global crisis: “Macroeconomics… invented by John Maynard Keynes…. The tests… are whether its adepts understand what might go wrong in the economy and how to put it right…

…When the financial crisis that hit in 2007 caught the profession almost completely unawares, it failed the first of these tests. It did better on the second. Nevertheless, it needs rebuilding…. The core macroeconomic model rested on two critical assumptions: the efficient markets hypothesis and rational expectations. Neither looks convincing…. It is questionable whether it is even possible to have “rational expectations” of a profoundly uncertain future…. Hyman Minsky’s view of the dangers of speculative tendencies in finance was roughly right, while many of the brightest macroeconomists proved precisely wrong. It is not good enough to argue that the canonical model works in normal times. We need also to understand the risks of crises and what to do about them….

A big question is not only whether we know how to respond to a crisis, but whether we did so. In his contribution, the Nobel laureate Paul Krugman argues, to my mind persuasively, that the basic Keynesian remedies—a strong fiscal and monetary response—remain right. Also vital is swift revitalisation of the banking system. The contrast between the swifter US recovery and the dreadful delays in the eurozone gives striking support for this view….

Fixing a huge crisis after the event is terribly hard. The obvious need then is to make economies more resilient…. Obvious solutions include eliminating the incentives towards leverage in our tax systems, encouraging greater use by the economy of equity finance and debt that can be readily converted into equity, raising the reserve and capital requirements of banks and moving swiftly towards the issuance of digital central bank cash…. We may never understand how such complex systems—animated, as they are, by human desires and misunderstandings — actually function. This does not mean that attempting to improve understanding is a foolish exercise. On the contrary, it is important. But it is arguably more vital in practice to focus on two other tasks… how to make the body economic more resistant… how to restore it to health as quickly as possible. On both counts, we need to think more and do more…