Where Modern Macroeconomics Went Wrong


Joseph Stiglitz over at INET Economics:

Dynamic Stochastic General Equilibrium (DSGE) models, which have played such an important role in modern discussions of macroeconomics, in my judgment fail to serve the functions which a well-designed macroeconomic model should perform. The most important challenge facing any macro-model is to provide insights into the deep downturns that have occurred repeatedly and what should be done in response. It would, of course, be even better if we had models that could predict these crises. From a social perspective, whether the economy grows next year at 3.1% or 3.2% makes little difference. But crises, when GDP falls and unemployment increases, have large consequences for individual well-being now as well as for future growth. In particular, it is now well recognized that periods of extended economic weakness such as confronted by the US and Europe after 2008 have significant implications for future potential growth.

While the 2008 crisis, and the inability of the DSGE model to predict that crisis or to provide policy guidance on how to deal with the consequences, precipitated current dissatisfaction with the model, the failings are deeper: the DSGE model fails similarly in the context of other deep downturns.

The DSGE models fail in explaining these major downturns, including the source of the perturbation in the economy which gives rise to them, why shocks, which the system (in these models) should have been able to absorb, get amplified with such serious consequences, and why they persist, i.e. why the economy does not quickly return to full employment, as one would have expected in an equilibrium model. These are not minor failings, but go to the root of the deficiencies in the model.

More here.