RETHINKING MACROECONOMICS: WHAT
FAILED, AND HOW TO REPAIR IT
Joseph E. Stiglitz
Columbia University
Abstract
The standard macroeconomic models have failed, by all the most important tests of scientific theory.
They did not predict that the financial crisis would happen; and when it did, they understated
its effects. Monetary authorities allowed bubbles to grow and focused on keeping inflation low,
partly because the standard models suggested that low inflation was necessary and almost sufficient
for efficiency and growth. After the crisis broke, policymakers relying on the models floundered.
Notwithstanding the diversity of macroeconomics, the sum of these failures points to the need for
a fundamental re-examination of the models—and a reassertion of the lessons of modern general
equilibrium theory that were seemingly forgotten in the years leading up to the crisis. This paper
first describes the failures of the standard models in broad terms, and then develops the economics
of deep downturns, and shows that such downturns are endogenous. Further, the paper argues that
there have been systemic changes to the structure of the economy that made the economy more
vulnerable to crisis, contrary to what the standard models argued. Finally, the paper contrasts the
policy implications of our framework with those of the standard models.
1. Introduction
Those who claim to be disciples of Adam Smith should be unhappy with what has
happened in the last few years. The pursuit of self-interest (sometimes called greed)
on the part of bank executives did not lead, as if by an invisible hand, to the well-being
of all; in fact it was disastrous for the banks, workers, taxpayers, homeowners, and the
economy more broadly. Only the bankers seemed to have fared well.
1
The editor in charge of this paper was Fabrizio Zilibotti.
Acknowledgments: Adam Smith Lecture presented at the European Economic Association annual
Congress, Glasgow, 24 August 2010. The author is University Professor, Columbia University, Chair
of the Management Board and Director of Graduate Summer Programs, Brooks World Poverty Institute,
University of Manchester, Senior Fellow and Chief Economist, Roosevelt Institute, and a member of
the Advisory Board, Institute for New Economic Thinking. I wish to thank Rob Johnson, Anton Korinek,
Jonathan Dingel, Mauro Gallegati, Stefano Battiston, Domenico Delli Gatti, Arjun Jayadev Eamon Kircher-
Allen, Sebastian Rondeau and Bruce Greenwald for helpful discussions and comments. Many of the ideas
are based on joint work with Greenwald (Greenwald and Stiglitz 1993, 2003a).
E-mail: jes322@columbia.edu
1. Of course, Smith himself took a broader perspective on self-interest than his modern-day disciples,
one which recognized some sensitivity to the effects of one’s actions on others. See, for instance, Nick
Phillipson (2010). Indeed, Rothschild (2001) and Kennedy (2009) argue that Smith used the term “invisible
hand” with some irony—with markedly different views about market perfection than those held by Smith’s
latter-day descendants.
Journal of the European Economic Association August 2011 9(4):591–645
c
2011 by the European Economic Association DOI: 10.1111/j.1542-4774.2011.01030.x
592 Journal of the European Economic Association
Modern general equilibrium theory has explained why markets are almost never
(constrained) Pareto efficient whenever there is imperfect and asymmetric information
or when risk markets are incomplete—which is always the case (see Greenwald and
Stiglitz 1986, 1988). Both before and after that paper, there have been a large number
of studies showing that even with rational expectations, markets are not in general
constrained Pareto efficient. Much of modern macroeconomics forgot these insights,
and constructed models centering around special cases where market inefficiencies do
not arise, and where the scope for welfare-enhancing government intervention, either
to prevent a crisis or to accelerate a recovery, is accordingly limited. This has made
the models of limited relevance either for prediction, explanation, or policy—at least
in times of severe downturns, when markets evidently are working so poorly.
Prediction is the test of a scientific theory. But when subject to the most important
test—the one whose results we really cared about—the standard macroeconomic
models failed miserably. Those relying on the Standard Model did not predict the crisis;
and even after the bubble broke, the Fed Chairman argued that its effects would be
contained.
2
They were not. In the months that followed, policymakers floundered—and
the Standard Model provided little guidance as to what they should do, for example the
best way to recapitalize the banks. Many of the critical policies before, during, and after
the crisis were based on analyses of modern macroeconomics. Monetary authorities
allowed bubbles to grow, partly because the Standard Models said there couldn’t be
bubbles. They focused on keeping inflation low, partly because the Standard Model
suggested that low inflation was necessary and almost sufficient for efficiency and
growth. They focused on nth-order distortions arising from price misalignments that
might result from inflation, ignoring the far larger losses that result (and have repeatedly
resulted) from financial crises. Belief in the efficiency of the market discouraged the
use of the full panoply of instruments (for example, restrictions on mortgage lending)
at the disposal of central banks and regulators; these would at least have dampened the
bubble and mitigated its consequences. Instead, it was repeatedly claimed that it would
be cheaper to clean up the aftermath of any bubble that might exist than to interfere
with the wonders of the market. Thus, while financial markets and regulators have
been widely blamed for the crisis, some of the blame clearly rests with the economic
doctrines on which they came to rely (Stiglitz 2010a).
There are some, such as Ben Bernanke (2010), who take a markedly different
view, arguing that economic science did not do a bad job. The fault, he argued, lay
not with economic science, but with economic management. I believe he is wrong—if
by economic science we mean the central macroeconomic models that have played
key roles in the formulation of economic policy and thinking in recent years. He is
right, of course, that there were many mistakes in the application of economic science.
Economic policymakers should have been aware, for instance, of the consequences of
the perverse incentive structures that had become prevalent within the financial sector.
2. On 28 March 2007 in testimony before the US Congress, after the bubble had already broken, the
Fed Chairman asserted: “the impact on the broader economy and financial markets of the problems in the
subprime market seems likely to be contained.”
Stiglitz Rethinking Macroeconomics: What Failed, and How to Repair It 593
But the standard macroeconomic models neither incorporated them nor provided an
explanation for why such incentive structures would become prevalent—and these
failures are failures of economic science.
3
Of course, there is enormous diversity within economics, and even within the
subfield of macroeconomics. Some macroeconomists warned of the looming bubble
and the consequences that would follow upon its bursting. Economists like Minsky, who
warned of the dangers of credit cycles (1992) or Kindleberger (1978), who described
repeated patterns of manias, panics, and crashes, have come back into fashion (see
also Reinhart and Rogoff 2009). Still, there was a single model, albeit with many
variations, that came to dominate, sometimes referred to as the DSGE (dynamic,
stochastic, general equilibrium) model.
4
At the risk of considerable oversimplification,
we refer to that model, and the standard policy prescriptions that were associated with
it, as the Standard Model, or the Conventional Wisdom (CW). As in other areas, such
simplifications help to clarify what is at issue.
Some advocates of that model recognize its limitations, arguing that it is, however,
just the beginning of a research strategy that will, over time, bring in more and more of
the relevant complexities of the world. Anything left out—agency problems, financial
constraints, and so forth—will eventually be incorporated. I will argue, to the contrary,
that that model is not a good starting point. Such Ptolemaic exercises in economics
will be no more successful than they were in astronomy in dealing with the facts of
the Copernican revolution.
Section 2 lays out in broad terms the failures of the Standard Model, while Section
3 develops the economics of deep downturns, arguing that the major disturbances
giving rise to such downturns are endogenous, not exogenous; this crisis is not just
an accident, the result of an unusually large epsilon, but is man-made. I explain
why economic systems often amplify shocks and why recoveries are sometimes so
slow. Section 4 argues that there have been systemic changes to the structure of the
economy—changes that, within the Standard Model, should have led to enhanced
stability, but which in fact made the economy more vulnerable to precisely the kind of
crisis that has occurred. Section 5 contrasts the policy implications of our framework
with that of the Standard Model.
3. There is a long list of flaws in the incentive structures, discussed and documented well before the crisis.
See, for example, Stiglitz (1982a, 1987a, 2003, 2010a) and Nalebuff and Stiglitz (1983a, 1983b). These
include: (i) incentive structures should have been based on relative performance—not, for example, stock
market value which could increase due to an industry shock or to an increase in equity prices; (ii) incentive
structures should have attempted to differentiate between increases in profitability due to increases in α
(hard to achieve) and to β (anyone can get higher average returns, simply by taking more risk). As designed,
the incentive structures encouraged excessive risk taking and bad accounting. The compensation schemes
were also not tax efficient. In practice, there was simply a weak relationship between pay and performance.
4. For a textbook treatment of both the basic classical and new Keynesian DSGE model, see Gal
´
ı 2008.
For a detailed analysis of the use of the New Keynesian model to evaluate monetary policy, see Woodford
(2003), and Clarida et al. (1999), and Gal
´
ı and Gertler (2007).
594 Journal of the European Economic Association
2. The Failure of Economic Science and Alternative Approaches
Any model is an idealization, an abstraction. The central challenge of macroeconomics
is to identify the salient aspects of the economy that help us explain what it is that we
want to explain. And that, of course, is where macro-economists begin to differ. What
is it that they seek to explain? And to what use do they want to put the model? Because
models can be used for different purposes, it makes little sense to strive for a single
model. Yet, to a large extent, the single model upon which much of macroeconomics
focuses is ill-suited for most of the purposes for which one might hope that such a
model might be used. It was of limited usefulness either for short-run prediction, ex
post interpretation, or the design of policies to prevent fluctuations, to minimize their
scale, or to respond once they occurred. In this paper, I am especially concerned with
deep downturns, such as the Great Recession or the Great Depression.
Economic Theory as Blinders. Models by their nature are like blinders. In leaving
out certain things, they focus our attention on other things. They provide a frame
through which we see the world. Psychologists have explained how we discount
information that is contrary to our cognitive frame. The result is that there can be
equilibrium fictions—given the information that individuals actually process, the world
as they see it supports their beliefs. For those believing in perfect markets, even repeated
crises are seen as rare events, accidents that don’t really need to be explained (see, for
example, Greif and Tabellini (2010) and Hoff and Stiglitz (2010). Shiller (2008) talks
about social contagion.)
The neoclassical investment function provides example of how theory can lead
modeling in the wrong direction. (As is typically the case, the problem lies not
with “theory” but with a specific theory.) For a long time, economists dismissed
incorporating cash flow effects into investment functions, even though empirical
studies (such as Kuh and Meyer 1957) suggested that they should be, because, it
was said, economic theory said that they such effects shouldn’t exist. But, only a
little later, economic theories that took into account capital market constraints arising
from imperfect information explained why such effects should be important, at least
at certain times. A vast subsequent literature established empirically the importance of
these constraints (see Gilchrist and Himmelberg 1995).
Trade-offs in Modeling. Because any model is a simplification, an idealization, of
reality, it is not a criticism to suggest that some aspect of reality has been left out. But
it is a criticism if what is left out is essential to understanding the problem at hand,
including the policy responses. If one is interested, for instance, in understanding
unemployment, it makes little sense to begin with a model that assumes that the labor
market clears.
In illuminating some questions, a model of two or three periods may have to
suffice—not because we believe that the world only lasts for three periods, but because
the complexities resulting from the infinite extension preclude incorporating more
important complexities. There are trade-offs in modeling just as there are in economics.
For instance, it has become acceptable, even fashionable, to use particular
parameterizations, for example, constant elasticity utility functions, often of the
Stiglitz Rethinking Macroeconomics: What Failed, and How to Repair It 595
Dixit–Stiglitz (1977) variety, and Cobb–Douglas production functions. In using them,
we should be aware not only of their special nature, but that they have empirical
predictions that can be (and typically are) refuted. For some purposes (such as the
analysis of behavior towards risk), these utility functions provide a bad description,
and one should use such models with extreme caution. When Dixit and I used the
particular utility function that has become fashionable, we chose it because it provided
the benchmark case where markets traded off optimal diversity and firm scale. The
diversity/quantity tradeoff was, we thought, the fundamental tradeoff in the theory
of monopolistic competition, and the partial equilibrium models that had been at the
center of the theory of monopolistic competition until then simply could not even
address this issue. We would never have thought to have concluded using that model
that markets were on average or in general efficient. Rather, a better interpretation was
that the market was almost surely inefficient; the direction of bias was a subject of
some complexity, though our model provided a framework within which one could
address that issue.
By the same token, if the distribution of income (say between labor and capital)
matters, for example, for aggregate demand and therefore for employment and output,
then using an aggregate Cobb–Douglas production function which, with competition,
implies that the share of labor is fixed, is not going to be helpful. The large changes
in the share of labor imply, of course, that such a model does not provide a good
description of what has happened.
If economics is the science of scarcity, economic modeling is the art and science of
selecting which among the many economic complexities to incorporate. The question,
then, is have the Standard Models focused on what is of critical importance, e.g. for
purposes of predicting the length and depth of the current downturn in employment or
output or the design of the policy responses?
2.1. The Representative Agent Model
While modern macroeconomics has gone well beyond the representative agent model,
that model has helped shape the direction of research. It is important to understand
its major limitations, and to assess the extent to which more recent developments, for
example in New Keynesian DSGE models, have failed to come to terms with these.
Methodological Missteps. The Standard Model takes as its methodological
foundation that macroeconomic behavior has to be derivable from underlying
microeconomic foundations. That proposition seems on the face of it uncontroversial.
But it was important that macroeconomics be based on the right microeconomic
assumptions, those consistent with actual behavior, taking into account information
asymmetries and market imperfections. Yet, in carrying out that research agenda,
particular microeconomic foundations (competitive equilibrium, rational expectations,
and so forth) were employed, and, to make the analysis tractable, particular
parameterizations, which in fact are inconsistent with microeconomic evidence, were
used (see Greenwald and Stiglitz 1987).