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Friday, September 21, 2018

The financial crisis and the foundations for macroeconomics [feedly]

The financial crisis and the foundations for macroeconomics
http://larrysummers.com/2018/09/13/the-financial-crisis-and-the-foundations-for-macroeconomics/

A, if not the, preoccupation of macroeconomists for the last generation has been providing macroeconomics with a microeconomic foundation. At one level this totally makes sense. How can one be against establishing foundations? And it makes sense to think that macroeconomic theories of fluctuations in investment, for example, should be rooted in theories of how individual businesses makes investment decisions.

Yet it has to be acknowledged that the principle of building macroeconomics on microeconomic foundations, as applied by economists, contributed next to nothing to predicting, explaining or resolving the Great Recession. The insights into the financial meltdown that policymakers found most valuable came from scholars, such as Hyman Minsky and Charles Kindleberger, who thought in terms of broad aggregates and made no effort to establish micro foundations. The market participants, such as Ray Dalio, who were most prescient with respect to the crisis ignored microeconomics as they theorized in terms of debt and credit aggregates.

What went wrong, and what is to be learned? In my view, the core supposition of much of macroeconomics, which is that it is best to operate with as fundamental a foundation as possible, is not supported by the history of science. Psychologists understand much of human behavior without thinking about neurons. Geologists product earthquakes without going back to the first principles of physics. Structural engineers use rules of thumb gained from experience for understanding the properties of materials used in construction.

So, too, macroeconomics need not be, and probably should not be, built on foundations that center on optimizing decisions by households and firms. For such an approach to be tractable too much needs to be abstracted from. In addition, recent research in behavioral economics suggests that optimization of the kind envisioned by economists is a poor model for understanding actual spending decisions.

But some kind of foundation is still required for macroeconomics. That is why I'm very excited by my friend Andrei Shleifer's new book with Nicola Gennaioli, "A Crisis of Beliefs: Investor Psychology and Financial Fragility." The book puts expectations at the center of thinking about economic fluctuations and financial crises — but these expectations are not rational. In fact, as all the evidence suggests, they are subject to systematic errors of extrapolation. The book suggests that these errors in expectations are best understood as arising out of cognitive biases to which humans are prone.

It starts with the work of Daniel Kahneman and Amos Tversky, showing how their ideas can be used to build tractable models of expectations in the economy. The approach helps to reevaluate the housing bubble before the financial crisis but also explains why investors and policymakers were so slow to catch on to the vulnerabilities of markets as the bubble began to deflate. It provides a persuasive account of the 2008 crisis and suggests the kind of perspectives that could have prevented or at least mitigated its consequences. And it points the way toward reducing future crisis risks.

To be sure there is much more work to do. The arguments that Gennaioli and Shleifer make need to be debated in the profession. And, yes, it is easier to explain the past than to predict the future. But theories of economic fluctuation and crisis based on the tendency of human beings to become too greedy and then too fearful seem much more fruitful than theories based on accurate optimization.

Something is wrong with the economics profession if events like those of 2008 do not change its thinking. Those wanting to be in the vanguard of the new thinking should be reading "A Crisis of Beliefs."


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