Looking Back, Moving Forward: Macroeconomics


By Justin Keay

Traditional economic theory has been challenged by recent market events in global financial markets, and that challenge has given rise to a new generation of economic soothsayers who are looking more deeply into the impact of finance on the real economy.

In mid-September 2007, desperate depositors started queuing up outside branches of Britain’s Northern Rock, amid growing fears the institution might collapse. According to then-chancellor of the Exchequer Alistair Darling, he and Bank of England governor Mervyn King were abroad watching events unfold on TV. King—an academic economist by training—said to him: “You know, they are behaving quite rationally.”

King’s remark demonstrated with startling clarity the importance of individual economic behavior on the broader economy, and vice versa, and the failure of global economic policy to account for, and be accountable to, humanity. King has been widely criticized for his inaction in the early days of the financial crisis when he held off injecting money into threatened institutions for fear of encouraging moral hazard.

In reality, very few economists anticipated the current crisis even though in retrospect the warning signs—the overgearing, the asset bubbles, the lack of financial market transparency—were plain to see. But hindsight is often 20/20. “We have entered a dark age for macroeconomics…all the theory taught in management schools proved completely useless in predicting the crisis,” says Jerry Caprio, an economist at Williams College in Massachusetts.

Since the Great Depression, the trend has been for an unambiguous orthodoxy—what John Kenneth Galbraith dubbed “the conventional wisdom”—to hold sway amid prevailing economic reality. In the years between 1945 and the 1970s, when the oil price explosion precipitated high inflation and a slump in demand, there was the Keynesian belief that governments could and should intervene. Over the 1980s and 1990s, supply-siders won the argument: The market was king, liberalization and privatization were the way forward. The more extreme version of this pro-market approach was dubbed “freshwater economics,” which held that financial markets are efficient and the broader economy was stable and self-correcting.

But now although freshwater economics is discredited, no new orthodoxy has been established. In the US, under president Obama, Keynes is still—relatively—king with the government pumping billions into the economy and issuing dollar bonds, which people will continue to buy, at least for a while, because the US is the US. By contrast in Europe, led by Germany, the mood seems to be that despite the debt crisis, there is little the government can do to mitigate things. So where does this leave the battered economics profession more generally?

Caprio says one of its failings was not to fully take on board the impact of the fast-evolving but really rather little understood finance sector on the wider economy.

To be fair, the profession is trying to make up for it: George Soros’ Institute of New Economic Thinking has already put out some very interesting work, while Paul Krugman’s stature grows with each of his critiques of what policymakers in Europe in particular are doing wrong. Joseph Stiglitz’ latest book, The Price of Inequality, stresses that markets are inefficient and have produced an inequality of wealth that has undermined our societies and economies. “Moving money from the middle and bottom of society to the top, as has increasingly been happening, far from stimulating entrepreneurship, actually produces slower growth and lower GDP but even more instability,” according to Stiglitz. Robert and Edward Skidelsky’s How Much is Enough suggests society is too focused on the material, and Michael Sandel’s What Money Can’t Buy looks at “the moral limits of markets.”

Although these are still early days and various crises continue to rock global markets, it seems the new orthodoxy that is taking shape will take into closer account the impact of economic change on humanity. Particularly for those who have lost out in this, the worst economic crisis in almost a century, it will be welcome news.