The current crisis and the culpability of macroeconomic theory

Abstract

The ideas at the heart of modern macroeconomics provided the intellectual justification of the economic policies of the past 10 to 15 years. It is these ideas which the financial crisis falsified. The dominant paradigm in macroeconomic theory over the past 30 years has been that of rational agents making optimal decisions under the assumption that they form their expectations about the future rationally—the rational agent using rational expectations, or RARE for short. The focus of the paper is on the way in which RARE deals with risk and uncertainty. It is this which is at the root of the problems, both for the discipline of economics and, much more importantly, for the economy itself and the financial crisis. Modern RARE macroeconomics bears a heavy burden of responsibility for the financial crisis. The discipline provided the intellectual underpinning for a world in which situations involving risk led to it being systematically underestimated, and in which situations of genuine uncertainty were not recognised for what they were.

Notes

For a statistical classification of the size and duration of recessions under capitalism since 1870, see Ormerod (Forthcoming, 2010).

For an early and powerful critique, see Summers (1986).

There have been attempts to identify monetary factors as the source of shocks in this theory, but without success.

This had no connection with the Federal Reserve.

The seminal article is by Black & Scholes (1973).