Saturos sent me a recent article in The Economist:
THE models that dismal scientists use to represent the way the economy works are sometimes found wanting. The Depression of the 1930s and the “stagflation” of the 1970s both forced rethinks. The financial crisis has sparked another.
The crisis showed that the standard macroeconomic models used by central bankers and other policymakers, which go by the catchy name of “dynamic stochastic general equilibrium” (DSGE) models, neither represent the financial system accurately nor allow for the booms and busts observed in the real world. A number of academics are trying to fix these failings.
Their first task is to put banks into the models. Today’s mainstream macro models contain a small number of “representative agents”, such as a household, a non-financial business and the government, but no banks. They were omitted because macroeconomists thought of them as a simple “veil” between savers and borrowers, rather than profit-seeking firms that make loans opportunistically and may themselves affect the economy.
This perspective has changed, to put it mildly. Hyun Song Shin of Princeton University has shown that banks’ internal risk models make them take more and more risk as asset prices rise, for instance.
. . .
In Australia Steve Keen, an economist, and Russell Standish, a computational scientist, are developing a software package that would allow anyone to create and play with models of the economy that incorporate some of these new ideas. Called “Minsky”””after Hyman Minsky, an American economist celebrated for his work on boom-and-bust financial cycles””it places the banking system at the centre of the economy.
A long road lies ahead, however. “Nobody has got something so convincing that the mainstream has to put up its hands and surrender,” says Paul Ormerod, a British economist. No model yet produces the frequent small recessions, punctuated by rare depressions, seen in reality. But “ultimately,” Mr Shin says, “macro is an empirical subject.” It cannot forever remain “impervious to the facts”.
In fact, macroeconomists grossly overrate the importance of banking. Robert Hall started off a recent survey article with the conventional wisdom:
The worst financial crisis in the history of the United States and many other countries started in 1929. The Great Depression followed. The second-worst struck in the fall of 2008 and the Great Recession followed. Commentators have dwelt endlessly on the causes of these and other deep financial collapses. Less conspicuous has been the macroeconomists’ concern about why output and employment collapse after a financial crisis and remain at low levels for several or many years after the crisis.
Talk about “impervious to facts”!! The financial crisis of 1931 occurred nearly two years after the Depression began, and was caused by the Great Depression. The fall of 2008 financial crisis was partly exogenous (the subprime fiasco), but greatly worsened by the severe fall in NGDP between June and December 2008. Most economists put far too much weight on banking crises as a causal factor, and far too little weight on monetary shocks, i.e. large unexpected changes in expected future NGDP.
Bank lending is not a causal factor—it mostly reflects the growth rate of NGDP.