Great Recession and Macroeconomic Theory: A Useless Crisis?

ABSTRACT

The global financial crisis of 2007–08 and the subsequent Great Recession have pushed many economists to acknowledge a fundamental limit in the theoretical models elaborated after the monetarist counter-revolution: these models disregard the financial system. The years following the Great Recession have thus been marked by the development of what can be called the ‘Financial Frictions Approach’, a theoretical approach based on the addition of the financial system to the New Keynesian DSGE model. The results of this line of research are beginning to appear also in macroeconomics textbooks. Significant examples are the publication of the seventh edition of Blanchard’s textbook, and the publication of the third edition of the textbook co-authored by Blanchard, Amighini and Giavazzi. The objective of this work is twofold: (i) to show that the new model presented by Blanchard, Amighini and Giavazzi, which reflects the results of the ‘Financial Frictions Approach’, does not allow to elaborate a coherent explanation of the Great Recession and (ii) to present the pillars of an alternative theoretical model based on the lessons of Keynes, Schumpeter and Minsky.

KEYWORDS:

• Financial frictions
• crises
• Keynes
• Schumpeter
• Minsky

JEL Classification:

• E10
• E20
• E30
• E40
• E44

Acknowledgements

The authors would like to thank the two anonymous referees for their very helpful comments that allowed to significantly improve this article. This work is dedicated to the memory of Giorgio Lunghini.

Disclosure Statement

No potential conflict of interest was reported by the authors.

Notes

1 See, for example, Blanchard (2014, 2015, 2018a, 2018b), Christiano, Eichenbaum, and Trabant (2018), Galì (2018), Gertler and Gilchrist (2018), Ghironi (2018), Hendry and Muellbauer (2018), Kehoe, Midrigan, and Pastorino (2018), Lindé (2018), and Vines and Wills (2018).

2 The results of the FFA are widely used not only in undergraduate textbooks but also in intermediate and advanced textbooks. See, amongst others, Carlin and Soskice (2015) and the fifth edition of David Romer’s (2019) Advanced Macroeconomics.

3 These leading macroeconomists are: Blanchard, Carlin and Soskice, Ghironi, Haldane and Turrell, Hendry and Muellbauer, Krugman, Lindé, McKibbin and Stoeckel, Reis, Stiglitz, Wren-Lewis, and Wright. Their answers have been published in 2018 by The Oxford Review of Economic Policy, vol. 34 (1–2).

4 “Given that the 2008 crisis originated in the financial sector, which the benchmark DSGE model assumed works frictionlessly, it is natural that almost all authors in this issue mention financial frictions. The assumption of ‘frictionless finance’ had the deep implication that finance had no causal role to play. […] There is general agreement that there is a need to focus on the deep mechanisms underlying these frictions” (Vines and Wills 2018, p. 21).

5 “I see the current DSGE models as seriously flawed, but they are eminently improvable and central to the future of macroeconomics” (Blanchard 2018b, p. 44).

6 “Hyman Minsky […] had warned for decades about the consequences of buildups in financial risk. […] Yet prevailing macroeconomic paradigms largely ignored the possibility of financial developments as drivers of economic performances. Neither financial euphoria as a source of booms nor financial crisis as a cause of busts played a prominent role in macroeconomic thinking of academics or policymakers” (Blanchard and Summers 2019, p. xvii).

7 Furthermore, Blanchard recognizes that the Great Recession prompted economists to rediscover the concept of hysteresis, as the data concerning advanced economies show that after the crisis ‘the level of output appears to have permanently been affected by the crisis and its associated recession’ (Blanchard 2017, p. 98).

8 “[…] we have […] entered a long-lasting period of secular stagnation, in which large negative safe interest rates would be needed for demand to equal potential output but monetary policy is constrained by the effective lower bound. In that case, budget deficits may be needed on a sustained basis to achieve sufficient demand and output growth” (Blanchard 2019a, p. 30).

9 For a thorough analysis of Blanchard’s thinking see Brancaccio and Califano (2019), Brancaccio and Saraceno (2017), and Gallegati (2019).

10 “It is easy to imagine a world in which there is a high level of saving and investment, but in which there is an unfavorable climate for financial intermediaries. At the extreme, each of the economy’s spending units — whether of the household, business, or government variety — would have a balanced budget on income and product account. For each spending unit, current income would equal the sum of current and capital expenditures. There could still be saving and investment, but each spending unit’s saving would be precisely matched by its investment in tangible assets. In a world of balanced budgets, security issues by spending units would be zero, or very close to zero. The same would be true of the accumulation of financial assets. Consequently, this world would be a highly uncongenial one for financial intermediaries; the saving–investment process would grind away without them” (Gurley and Shaw 1956, pp. 257–258).

11 Bennett McCallum illustrates why the mainstream approach focuses on the money market and neglects the financial markets as follows:

[C]an it be sensible to discuss monetary economics with little attention devoted to the workings of financial markets? […] The question’s answer is […] fairly straightforward. It rests basically on the fact that in making their borrowing and lending decisions, rational households (and firms) are fundamentally concerned with goods and services consumed or provided at various points in time. They are basically concerned, that is, with choices involving consumption and labor supply in the present and in the future. But such choices must satisfy budget constraints and thus are precisely equivalent to decisions about borrowing and lending — that is, supply and demand choices for financial assets. Thus, for example, a household that chooses to consume this year in excess of this year’s income equivalently chooses to borrow (or to draw down its assets) to the required extent. Consequently, there is no need to consider both types of decisions explicitly. The practice adopted in this book is to focus attention on consumption/saving decisions rather than on borrowing/lending decisions, letting the latter be determined implicitly. (McCallum 1989, pp. 29–30)

12 See, for example, Bernanke (1992–93, 2007), Bernanke and Blinder (1988), Bernanke and Gertler (1995), Bernanke and Lown (1991), Bernanke, Gertler, and Gilchrist (1999), Gorton and Winton (2002), Levine (2002, 2004), Stiglitz and Greenwald (2003), Stulz (2001), and Wurgler (2000).

13 For example, David Romer observes that due to the presence of information asymmetries ‘institutions such as banks, mutual funds, and bond-rating agencies that specialize in acquiring and transmitting information play central role in financial markets. But even they can be much less informed than the firms or individuals in whom they are investing their funds’ (Romer 2019, p. 464). Minsky was very doubtful with regard to the validity of an approach in which the ‘non neutrality [of money] depends upon borrowers being smart and bankers being dumb’ (Minsky 1993a, p. 79).

14 As a reminder, the model described by Blanchard, Amighini and Giavazzi (BAG 2017, p. 48) and the benchmark DSGE model are based on this assumption. On this point, see, for example, Brunnermeier, Eisenbach and Sannikov (2013) and Romer (2019).

15 “The need for credit arises from the discrepancy between individuals’ resource endowments and investment opportunities. This can be seen most simply if we imagine a primitive agricultural economy, where different individuals own different plots of land and have different endowments of seed with which to plant the land. (For simplicity we assume that seed is the only input.) The marginal return to additional seed on different plots of land may differ markedly. National output can be increased enormously if the seed can be reallocated from plots of land where it has a low marginal product to plots where it has a high marginal product. But this requires credit, that is, some farmers will have to get more seed than their endowment in return for a promise to repay the loan in the next period, when the crop is harvested. Banks are the institutions within this society for screening the loan applicants, for determining which plots have really high marginal returns, and for monitoring, for ensuring that the seeds are actually planted, rather than, say, consumed by the borrower in a consumption binge” (Stiglitz and Weiss 1990, pp. 91–92).

16 Even in a corn economy farmers can go bankrupt because of bad weather conditions, wars, earthquakes or plagues, that is, phenomena that Schumpeter defined as external factors ‘which act from without the economic sphere’ (Schumpeter [1939] 1964, p. 1). These factors should therefore be excluded from the economic analysis.

17 As underlined by Donzelli (1988) and Desai (2010, 2014), the validity of Wicksell’s thesis is limited to the case of an economic system in which the production of a single homogeneous good occurs through an unchanging technology.

18 “Not surprisingly, in the aftermath of the 2008 financial crisis there is a growing consensus that at least one critical failing of the standard model is its (non)-treatment of the financial sector. Financial frictions, as they have come to be called, are important. These include credit and equity rationing and the corollary importance of collateral constraints and of banks […]” (Stiglitz 2018, p. 84).

19 “The theory that we developed can be thought of as a generalization of the loanable funds theory. […] We argue that what matters is not just a supply of savings, funds that are not spent on consumption goods, but a supply of credit, credit that can finance investment of firms or consumption of households; that financial institutions play a pivotal role in determining the supply of credit; that there can be large changes in the supply of credit over the business cycle […]” (Stiglitz and Greenwald 2003, pp. 45–46; see also Stiglitz 2016). On the loanable funds theory, see Bertocco (2013).

20 “The fact that the return received by lenders may decrease with an increase in the interest rate has one further effect: it means that there may be credit rationing. […] It should be emphasized that these arguments apply so long as the bank does not have perfect information concerning borrowers” (Stiglitz and Weiss 1990, p. 98).

21 For an analysis of Minsky’s thinking, see Minsky (1975, 1980, 1982, 1986a, 1986b, 1996), Nikolaidi and Stockhammer (2017), Tymoigne and Wray (2013), and Wray (2016).

22 As observed by Reis, this attitude leads to attach importance only to the latest developments of the discipline: ‘Mortality imposes that the future of macroeconomics will be shaped by the youngest members of the profession. There is something wrong with a field when bright young minds no longer find its questions interesting, or just reproduce the thoughts of closeminded older members’ (Reis 2018, p. 134).

23 To explain the role of bank money, Schumpeter hypothesizes the existence of full employment conditions. But despite Schumpeter’s claims, it can be shown that the fundamental role of bank money in capitalist economies does not depend on the presence of full employment (on this point see Bertocco and Kalajzić 2019a, 2019b).

24 The investment decisions described by Keynes in The General Theory correspond to Schumpeter’s innovations:

The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence. (Keynes [1936] 2013, pp. 149–150)

25 “The classical theory supposes that the readiness of the entrepreneur to start up a productive process depends on the amount of value in terms of product which he expects to fall to his share; i.e. that only an expectation of more product for himself will induce him to offer more employment. But in an entrepreneur economy this is a wrong analysis of the nature of business calculation. An entrepreneur is interested, not in the amount of product, but in the amount of money which will fall to his share. He will increase his output if by so doing he expects to increase his money profit, even though this profit represents a smaller quantity of product than before” (Keynes [1933b] 2013, p. 82).

26 “An act of individual saving means — so to speak — a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or to consume any specified thing at any specified date. […] the act of saving implies […] a desire for ‘wealth’ as such, that is for a potentiality of consuming an unspecified article at an unspecified time” (Keynes [1936] 2013, pp. 210–211).

27 “We have derived the natural rate of unemployment and, by implication, the associated level of output, under two assumptions. First, we have assumed equilibrium in the labour market. Second, we have assumed that the price level was equal to the expected price level” (BAG 2017, p. 148).

28 This example is based on the linear model presented in Bertocco and Kalajzić (2019a, 2019b), which illustrates the validity of the principle of effective demand within a monetary economy characterized by the production of a multiplicity of goods.

29 For a detailed description of the endogenous nature of the contemporary crisis, see Bertocco (2017), and Bertocco and Kalajzić (2018b).