"Rare Events" and Asset Prices
Good Beat Reporters

Simon Wren Lewis on Bad Economics

Simon Wren Lewis:

mainly macro: Crisis, what crisis? Arrogance and self-satisfaction among macroeconomists: Let me be absolutely clear that I am not saying that macroeconomics has nothing to learn from the financial crisis. What I am suggesting is that when those lessons have been learnt, the basics of the macroeconomics we teach will still be there. For example, it may be that we need to endogenise the difference between the interest rate set by monetary policy and the interest rate actually paid by firms and consumers, relating it to asset prices that move with the cycle. But if that is the case, this will build on our current theories of the business cycle. Concepts like aggregate demand, and within the mainstream, the natural rate, will not disappear. We clearly need to take default risk more seriously, and this may lead to more use of models with multiple equilibria (as suggested by Chatelain and Ralf, for example). However, this must surely use the intertemporal optimising framework that is the heart of modern macro.

Why do I want to say this? Because what we already have in macro remains important, valid and useful. What I see happening today is a struggle between those who want to use what we have, and those that want to deny its applicability to the current crisis….

Since 2010… policymakers around the world [have been] using ideas that contradict basic macro theory, like expansionary austerity… monetary policy makers appear to be misunderstanding ideas that are part of that theory, like credibility. In this context, saying that macro is all wrong and we need to start again is not helpful….

[T]he interesting question for me is how those that did look at this data [in the mid-2000s] managed to convince themselves that, to use the title from Reinhart and Rogoff’s book, this time was different. One answer was that they were convinced by economic theory that turned out to be wrong. But it was not traditional macro theory – it was theories from financial economics. And I’m sure many financial economists would argue that those theories were misapplied…. Believing that evidence of arbitrage also meant that fundamentals were correctly perceived. In retrospect, we can see why those ideas were wrong using the economics toolkit we already have. So why was that not recognised at the time? I think the key to answering this does not lie in any exciting new technique from physics or elsewhere, but in political science.

To understand why regulators and others missed the crisis, I think we need to recognise the political environment at the time, which includes the influence of the financial sector itself. And I fear that the academic sector was not exactly innocent in this either. A simplistic take on economic theory (mostly micro theory rather than macro) became an excuse for rent seeking…