Should the financial crisis inspire normative revision?

Abstract

The paper evaluates the claim, made by a range of commentators but most prominently by Akerlof and Shiller in Animal Spirits, that the recent financial crisis illustrates gaps in the normative picture incorporated into standard macroeconomics that are plugged by insights due to behavioral economics. It is argued that Akerlof and Shiller's contention that we cannot understand what happened unless we supplement macroeconomic theory with social-psychological theory is convincing only after being so heavily qualified that most of the surface excitement drains out of it. However, this is argued to be compatible with the idea that each recession or depression is a unique historical episode from which specific lessons can be learned; rejection of calls for paradigm shifts does not imply that each business cycle merely offers another observation to confirm a settled and stable understanding of macroeconomic dynamics. Discussion of factors that made the recent crisis unusually dangerous – the extreme global savings imbalance and the very rapid shifts occurring in the composition of the global labor force – leads to identification of a quite specific normative recommendation. This recommendation, that wealthy and middle-income people who care about efficiency, growth and prosperity should be willing to be taxed at higher levels to fund investments in human capital development, is certainly far from novel. However, I contend that the recent events have provided a new and newly specific reason to urge it. The reasoning in question owes nothing to behavioral economics or to any new advances in empirical psychology, which are indeed argued to obscure the most important implications of the recent crisis, and of recessions in general.

Keywords:

• 2008–2009 financial crisis
• behavioral economics
• normative reforms
• standard macroeconomics
• global structural shift

JEL Codes::

• A125
• A13
• B50
• E32
• E60

Acknowledgement

I thank Kevin Hoover for extremely helpful suggestions following an earlier draft of the paper.

Notes

1. Note, by the way, that Berle could hardly have been described as a populist.

2. For a recent iteration, see Marglin (2008).

3. See Coleman (2002) for a critical history of this popular variant of anti-economics, and Ross (in press) for analysis.

4. See e.g. Ariely (2008).

5. As Kevin Hoover (personal correspondence) points out, ‘turning points in business cycles’ allows for more than one precise interpretation. However, Akerlof and Shiller do not provide a formal model in their book, and avoid what they take to be economist's ‘jargon’ in their verbal descriptions. I think it is clear from context that they assert two facts: (1) psychological factors explain the timing of peaks and troughs in cycles, on some unspecified scale; and (2) the operation of these factors amplifies the magnitude of the differences between peaks and troughs within cycles.

6. This is not in itself a brief for privileging the target most criticized by Sen, per capita income. In contemporary applied development economics, mean weighted household consumption expenditure is generally regarded as a more reliable measure; see Bhorat, Leibbrandt, Maziya, van den Berg, and Woolard (2001).

7. Thanks to Kevin Hoover for pointing this out.