1
From Triumph to Crisis in Economics

There was a time when the question this book poses would have generated derisory guffaws from leading economists – and that time was not all that long ago. In December 2003, the Nobel Prize winner Robert Lucas began his Presidential Address to the American Economic Association with the triumphant claim that economic crises like the Great Depression were now impossible:

Macroeconomics was born as a distinct field in the 1940s, as a part of the intellectual response to the Great Depression. The term then referred to the body of knowledge and expertise that we hoped would prevent the recurrence of that economic disaster. My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades. (Lucas, 2003, p. 1, emphasis added)

Four years later, that claim fell apart, as first the USA and then the global economy entered the deepest and longest crisis since the Great Depression. Almost a decade later, the recovery from that crisis is fragile at best. The question of whether another financial crisis may occur can no longer be glibly dismissed.

That question was first posed decades earlier by the then unknown but now famous maverick American economist Hyman Minsky. Writing two decades before Lucas, Minsky remarked that ‘The most significant economic event of the era since World War II is something that has not happened: there has not been a deep and long-lasting depression’ (1982, p. ix).1 In contrast, before the Second World War, ‘serious recessions happened regularly . . . to go more than thirty-five years without a severe and protracted depression is a striking success’. To Minsky, this meant that the most important questions in economics were:

Can ‘It’ – a Great Depression – happen again? And if ‘It’ can happen, why didn’t ‘It’ occur in the years since World War II? These are questions that naturally follow from both the historical record and the comparative success of the past thirty-five years. (1982, p. xii)

Minsky’s ultimate conclusion was that crises in pure free-market capitalism were inevitable, because thanks to its financial system, capitalism ‘is inherently flawed, being prone to booms, crises, and depressions:

This instability, in my view, is due to characteristics the financial system must possess if it is to be consistent with full-blown capitalism. Such a financial system will be capable of both generating signals that induce an accelerating desire to invest and of financing that accelerating investment. (Minsky, 1969, p. 224)

A serious crisis hadn’t occurred since the Second World War, Minsky argued, because the post-war economy was not a pure free-market system, but rather was a mixed market–state economy where the state was five times larger than it was before the Great Depression. A crisis had been prevented because spending by ‘Big Government’ during recessions had prevented ‘the collapse of profits which is a necessary condition for a deep and long depression’ (Minsky, 1982, p. xiii).

Given that Minsky reached this conclusion in 1982, and that Lucas’s claim that the problem ‘of depression prevention has been solved . . . for many decades’ occurred in 2003, you might think that Lucas, like Minsky, thought that ‘Big Government’ prevented depressions, and that this belief was proven false by the 2008 crisis.

If only it were that simple. In fact, Lucas had reached precisely the opposite opinions about the stability of capitalism and the desirable policy to Minsky, because the question that preoccupied him was not Minsky’s ‘Can “It” – a Great Depression – happen again?’, but the rather more esoteric question ‘Can we derive macroeconomic theory from microeconomics?’

Ever since Keynes wrote The General Theory of Employment, Interest and Money (1936), economists have divided their discipline into two components: ‘microeconomics’, which considers the behaviour of consumers and firms; and ‘macroeconomics’, which considers the behaviour of the economy as a whole. Microeconomics has always been based on a model of consumers who aimed to maximise their utility, firms that aimed to maximise their profits, and a market system that achieved equilibrium between these two forces by equating supply and demand in every market. Macroeconomics before Lucas, on the other hand, was based on a mathematical interpreta-tion of Keynes’s attempt to explain why the Great Depression occurred, which was developed not by Keynes but by his contemporary John Hicks.

Though Hicks himself regarded his IS-LM model (‘Investment-Savings & Liquidity-Money’) as compatible with microeconomic theory (Hicks, 1981, p. 153; 1937, pp. 141–2), Lucas did not, because the model implied that government spending could boost aggregate demand during recessions. This was inconsistent with standard microeconomics, which argued that markets work best in the absence of government interventions.

Starting in the late 1960s, Lucas and his colleagues developed an approach to macroeconomics which was derived directly from standard microeconomic theory, which they called ‘New Classical Macroeconomics’. In contrast to the IS-LM model, it asserted that, if consumers and firms were rational – which Lucas and his disciples interpreted to mean (a) that consumers and firms modelled the future impact of government policies using the economic theory that Lucas and his colleagues had developed, and (b) that this theory accurately predicted the consequences of those policies – then the government would be unable to alter aggregate demand because, whatever it did, the public would do the opposite:

there is no sense in which the authority has the option to conduct countercyclical policy . . . by virtue of the assumption that expectations are rational, there is no feedback rule that the authority can employ and expect to be able systematically to fool the public. (Sargent & Wallace, 1976, pp. 177–8)

Over the next few decades, this vision of a microfounded macroeconomics in which the government was largely impotent led to the development of complicated mathematical models of the economy, which became known as ‘Dynamic Stochastic General Equilibrium’ (DSGE) models.

This intellectual process was neither peaceful nor apolitical. The first models, known as ‘Real Business Cycle’ (RBC) models, assumed that all markets worked perfectly, and asserted that all unemployment was voluntary – including the 25 per cent unemployment rates of the Great Depression (Prescott, 1999; Cole & Ohanian, 2004). This was too much for many economists, and what is now known as the ‘Freshwater–Saltwater’ divide developed within the mainstream of the profession.

The more politically progressive ‘Saltwater’ economists (who described themselves as ‘New Keynesians’) took the RBC models developed by their ‘Freshwater’ rivals and added in ‘market imperfections’ – which were also derived from standard microeconomic theory – to generate DSGE models. The market imperfections built into these models meant that if the model economy were disturbed from equilibrium by a ‘shock’, ‘frictions’ due to those imperfections would slow down the return to equilibrium, resulting in both slower growth and involuntary unemployment.

These ‘New Keynesian’ DSGE models came to dominate macroeconomic theory and policy around the world, and by 2007 they were the workhorse models of Treasuries and Central Banks. A representative (and, at the time, very highly regarded) DSGE model of the US economy had two types of firms (final goods producers operating in a ‘perfect’ market, and intermediate goods producers operating in an ‘imperfect’ one); one type of household (a worker–capitalist–bond trader amalgam that supplied labour via a trade union, earnt dividends from the two types of firms, and received interest income from government bonds); a trade union setting wages; and a government sector consisting of a revenue-constrained, bond-issuing fiscal authority and an activist Central Bank, which varied the interest rate in response to deviations of inflation and GDP growth from its target (Smets & Wouters, 2007).

Notably, a government that could affect employment by fiscal policy was normally absent from DSGE models, as was a financial sector – and indeed money itself. The mindset that developed within the economics profession – and especially within Central Banks – was that these factors could be ignored in macroeconomics. Instead, if the Central Bank used DSGE models to guide policy, and therefore set the interest rate properly, economic growth and inflation would both reach desirable levels, and the economy would reach a Nirvana state of full employment and low inflation.

Right up until mid-2007, this model of the economy seemed to accurately describe the real world. Unemployment, which had peaked at 11 per cent in the USA in the 1983 recession, peaked at under 8 per cent in the early 1990s recession...