Great Recession and Macroeconomic Theory: a Critical Analysis of the Blanchard, Amighini and Giavazzi Textbook
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Great Recession and macroeconomic theory: a critical analysis of the Blanchard, Amighini and Giavazzi textbook Giancarlo Bertocco*, Andrea Kalajzić** * University of Insubria, Varese, Italy. ** University of Insubria, Varese, Italy. This work is dedicated to the memory of Giorgio Lunghini Abstract The global financial crisis of 2007-2008 and the subsequent Great Recession have pushed many economists to acknowledge a fundamental limit in the theoretical models elaborated after the monetarist counter-revolution started with Friedman’s criticism of the Phillips curve: these models neglect the financial system. The years following the Great Recession have thus been marked by the development of what can be called ‘Financial Frictions 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 (Blanchard 2017), and the publication of the third edition of the textbook co- authored by Blanchard, Amighini and Giavazzi (2017). The authors acknowledge that the mainstream economic model presented in the previous editions of their textbooks is unable to offer a significant explanation of the causes of the crisis as it completely neglects the role of the financial system. In the revised editions of their textbooks they present a new theoretical model taking into account the financial system. The objective of this work is twofold: i) to show that the new model 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. JEL Classification: E10, E20, E30, E40, E44. Key words: Financial markets, Crises, Keynes, Schumpeter, Minsky. 1 Introduction The global financial crisis of 2007-2008 and the subsequent Great Recession have pushed many economists to acknowledge a fundamental limit in the theoretical models elaborated after the monetarist counter-revolution started with Friedman’s criticism of the Phillips curve: these models neglect the financial system. The years following the Great Recession have thus been marked by the development of what can be called ‘Financial Frictions Approach’ (hereafter FFA) based on the addition of the financial system to the New Keynesian DSGE model.1 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 (Blanchard 2017), and the publication of the third edition of the textbook co-authored by Blanchard, Amighini and Giavazzi (2017, hereafter BAG). 2 The distinctive feature of the new editions of these textbooks, compared to other well-known textbooks such as that by Mankiw (2016), consists in recognizing that the New Keynesian DSGE model elaborated over the last decades is unable to offer a significant explanation of the causes of the Great Recession because it completely neglects the role played by the financial system in modern market economies. To explain the origins of the Great Recession BAG have therefore developed a new version of their theoretical model explicitly taking into account the financial system. 1 See, for example, Blanchard (2014, 2015, 2018b), Vines and Mills (2018), Ghironi (2018), Lindé (2018), Hendry and Muellbauer (2018), Gertler and Gilchrist (2018), Galì (2018), Christiano et al. (2018) and Kehoe et al. (2018). 2 The results of the FFA are widely used not only in undergraduate textbooks, but also in intermediate and advanced textbooks. Among these see, in particular, Carlin and Soskice (2015) and the fifth edition of David Romer’s Advanced Macroeconomics. 2 The aim of this work is twofold. First, to show that the new BAG’s theoretical model, which reassumes the results of the FFA, is unable to offer a significant explanation of the causes of the Great Recession. This conclusion is confirmed by the fact that BAG are forced to use concepts and relationships that are at odds with the foundations of their theoretical framework. To overcome this contradiction, it is necessary to develop a different theoretical model consistent with the concepts and relationships used by BAG to explain the economic phenomena observed over the last decades. The second objective of this work thus consists in presenting the pillars of an alternative theoretical paradigm based on the theories developed by Keynes, Schumpeter and Minsky who underlines the reasons justifying the non neutrality of money and finance and explain the endogenous nature of economic crises. The paper is divided into three parts. In the first part we summarize the main features of the theoretical model developed by BAG and their interpretation of the origins of the Great Recession. In the second part we analyze the limits of this model and of the FFA. Finally, in the third part we present the basic elements of an alternative theoretical paradigm allowing to explain the endogenous nature of the contemporary crisis. 1. The model of Blanchard, Amighini and Giavazzi 1.1 The Great Recession and the ‘Financial Frictions Approach’ In the new edition of their textbook BAG (2017) acknowledge that the Great Recession has highlighted the failure of macroeconomics. According to BAG, the limit of the mainstream macroeconomic model developed over the four decades preceding the outbreak of the crisis was the failure to take into account the role played by the financial system: 3 There is no question that the crisis reflects a major intellectual failure on the part of macroeconomics. The failure was in not realizing that such a large crisis could happen, that the characteristics of the economy were such that a relatively small shock, in this case the decrease in U.S. housing prices, could lead to a major financial and macroeconomic global crisis. The source of this failure, in turn, was insufficient focus on the role of the financial institutions in the economy. By and large, the financial system, and the complex role of banks and other financial institutions in the intermediation of funds between lenders and borrowers, was ignored. (BAG 2017, p. 518) Over the last hundred years, two significant and unexpected events have led the economics profession to abandon the generally accepted theory of the time and to replace it with a different paradigm. In the 1930s the Great Depression undermined the confidence in the neoclassical theory, according to which economic crises were nothing more than accidental phenomena bound to die out spontaneously thanks to the normal functioning of the markets. In 1936 the publication of Keynes’s General Theory of Employment, Interest and Money unveiled the elements of a revolutionary theoretical approach whereby economic crises were structural phenomena. The second turning point occurred in the 1970s when Western economies were hit by a new global economic crisis characterized by a combination of low growth and high inflation that became known as ‘stagflation’. The crisis of the 1970s led Milton Friedman to strongly criticize the then dominant theoretical approach, and to emphasize that Keynesian policies can be effective only if workers are affected by ‘monetary illusion’. Past experience therefore leads to wonder whether the Great Recession will be followed by a new theoretical revolution. Gärtner et al. (2013) have tried to answer this question through an inquiry that involved 768 teachers working at 512 colleges and universities in Western Europe and in the United States. Only 10 percent of respondents 4 believe that “modern macroeconomics possesses the models and concepts needed to understand and deal with such crises” (Gärtner 2013, p. 408). The great majority of respondents (72 percent) instead recognizes that the Great Recession has revealed significant limitations of the New Keynesian DSGE models. Nevertheless, these respondents are convinced that New Keynesian DSGE models should not be abandoned. Just a small minority of respondents (17 percent) argues for the necessity to elaborate an alternative theoretical paradigm. These results have been confirmed by the investigation conducted by Aigner et al. (2018), which compares the contents of economic literature before and after the crisis through a bibliometric approach. Further confirmation can be found in the work of Vines and Wills (2018, p. 1), who “asked a number of leading macroeconomists to describe how the benchmark New Keynesian model might be rebuilt in the wake of 2008 crisis.”3 Vines and Wills conclude that the generality of economists surveyed has underlined the necessity to develop a new version of the benchmark DSGE model based on the abandonment of the ‘frictionless finance’ hypothesis and the introduction of the FFA.4 Oliver Blanchard is among the most prestigious supporters of the FFA. He recognizes that the crisis has induced economists to rediscover the concept of hysteresis since the data of advanced economies show that after the Great Recession “the level of output appears to 3 These leading macroeconomists are: O. Blanchard, S. Wren-Lewis, J. Stiglitz, R. Wright, R. Reis, P. Krugman, W. Carlin and D. Soskice, F. Ghironi, A. Haldane and A. Turrell, J. Lindé, D. Hendry and J. Muellbauer, and W. McKibbin and A. Stoeckel. Their answers have been published by The Oxford Review of Economic Policy, vol. 34, 1-2, 2018. 4 “Given that the 2008 crisis originated in the financial sector,