The Impact of the 2008-09 Financial Crisis on Macroeconomic Theory

How did macroeconomics stand in the wake of the so-called Great Recession (an analogy with the Great Depression of the 1930s)? These events brought out at least two blind spots in the dynamic stochastic approach to macroeconomics (that is, DSGE mod­elling in general).

This marks a clear analogy with the situation faced by Keynes in the 1930s. Equilibrium models convey a Panglossian view, to borrow Keynes’s characterisation (all is for the best in this best of all possible worlds), of the working of the economy as they rule out the possibility that markets can fail and that agents may find themselves in a state where they are unable to achieve their optimising plan (Keynes 1936: 33). When the economy is in a state of plain sailing, this neglect is admissible, but it is no longer justifiable when the economy shows signs of collapse. Whatever the virtues of the new-classical real business-cycle methodology, its limits are clear. To “old” Keynesians, this has the sweet smell of revenge. New voices have arisen proclaiming the need to return to Keynes’s General Theory. Robert Skidelsky, Keynes’s biographer and the author of The Return of the Master (Skidelsky 2009), and Paul Krugman - the 2008 laureate of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel - (see, for example, Krugman 2010) are two prominent figures in this movement (not to mention Posner’s rediscovery of Keynes’s book - Posner 2009). In Krugman’s words, “Keynesian econom­ics remains the best framework we have for making sense of recessions and depressions” (2009: 8).

The Great Recession will certainly have an impact on the course of macroeconomics. The clearest sign of this is the widespread admission that the loose integration of finance into macroeconomic models was a serious mistake, and the ensuing surge of work aiming to fill this gap. At this juncture, it is, however, still difficult to gauge whether a mere inte­gration of the financial sector within the existing framework will suffice, or whether the Great Recession will trigger a more radical reorientation of macroeconomics.

Michel De Vroey and Pierre Malgrange