Mainstream Macroeconomics Is Junk
By Paul De Grauwe, July 21 2009
How to resolve this crisis in macroeconomics? The field must be revamped fundamentally. Some of its shortcomings are obvious. Before the financial crisis, most macroeconomists were blinded by the idea that efficient markets would take care of themselves. They did not bother to put financial markets and the banking sector into their models. This is a major flaw.
There is a deeper problem, though, that will be more difficult to resolve. This is the underlying paradigm of macroeconomic models. Mainstream models take the view that economic agents are superbly informed and understand the deep complexities of the world. In the jargon, they have “rational expectations”. Not only that. Since they all understand the same “truth”, they all act in the same way. Thus modelling the behaviour of just one agent (the “representative” consumer and the “representative” producer) is all one has to do to fully describe the intricacies of the world. Rarely has such a ludicrous idea been taken so seriously by so many academics.
We need a new science of macroeconomics. A science that starts from the assumption that individuals have severe cognitive limitations; that they do not understand much about the complexities of the world in which they live. This lack of understanding creates biased beliefs and collective movements of euphoria when agents underestimate risk, followed by collective depression in which perceptions of risk are dramatically increased. These collective movements turn uncorrelated risks into highly correlated ones. What Keynes called “animal spirits” are fundamental forces driving macroeconomic fluctuations.
The basic error of modern macroeconomics is the belief that the economy is simply the sum of microeconomic decisions of rational agents. But the economy is more than that. The interactions of these decisions create collective movements that are not visible at the micro level.
It will remain difficult to model these collective movements. There is much resistance. Too many macroeconomists are attached to their models because they want to live in the comfort of what they understand – the behaviour of rational and superbly informed individuals.
To paraphrase Isaac Newton, macroeconomists can calculate the motions of a lonely rational agent but not the madness of the crowds. Yet if macroeconomics wants to become relevant again, its practitioners will have to start calculating this madness. It is going to be difficult, but that is no excuse not to try.
It’s called Austrian economics