Economics is, like medicine (and unlike, say, cosmology), a practical discipline. Its goal is to make the world a better place. This is particularly true of macroeconomics, which was invented by John Maynard Keynes in response to the Great Depression. The tests of this discipline are whether its adepts understand what might go wrong in the economy and how to put it right. When the financial crisis that hit in 2007 caught the profession almost completely unawares, it failed the first of these tests. It did better on the second. Nevertheless, it needs rebuilding.
In a blog for the Financial Times in 2009, Willem Buiter, now at Citi, argued that: “Most mainstream macroeconomic theoretical innovations since the 1970s . . . have turned out to be self-referential, inward-looking distractions at best.” An exceptionally thorough analysis, published in the Oxford Review of Economic Policy, under the title “Rebuilding Macroeconomic Theory”, leads this reader to much the same position. The canonical approach did indeed prove gravely defective. Moreover, top class professional economists differ profoundly on what to do about it. Socrates might say that awareness of one’s ignorance is far better than the illusion of knowledge. If so, macroeconomics is in good shape.
As David Vines and Samuel Wills explain in their excellent overview, the core macroeconomic model rested on two critical assumptions: the efficient markets hypothesis and rational expectations. Neither looks convincing today. It is questionable whether it is even possible to have “rational expectations” of a profoundly uncertain future. Such uncertainty helps explain the existence of institutions — money, debt and banks — whose effects are so significant and yet were largely ignored in standard models. It is better to be roughly right than precisely wrong. Thus, Hyman Minsky’s view of the dangers of speculative tendencies in finance was roughly right, while many of the brightest macroeconomists proved precisely wrong.