Macroeconomics tends to advance—or, at least, to change—one crisis at a time. The Great Depression discredited the idea that economies were basically self-correcting, and the following decades saw the development of Keynesian theory and the use of fiscal stimulus. The stagflation of the 1970s led to the development of real business cycle models, which saw recessions as the efficient working of the economy, and central bank meddling as likely only to cause inflation. The painful recessions of the early 1980s saw a shift to so-called New Keynesian models, in which monetary policy is the central stabilizing force in the economy.
The housing bubble that peaked in 2006, the financial crisis of 2008, and the Great Recession that followed constitute another crisis. So far, however, it has produced mostly evolution, rather than revolution, in economists’ conception of the business cycle. The bubble and the following crisis convinced macroeconomists that recessions often emanate from the financial sector—an idea that had often been resisted or overlooked before. There was immediately a flurry of activity, as economists hastened to shoehorn finance into their standard models. Some now believe that the addition of finance will allow New Keynesian models to forecast crises before they happen; others are, understandably, sceptical.
Another important insight from the Great Recession was that traditional monetary policy isn’t always enough to stabilize the economy—when interest rates hit zero, other measures are needed. These could include quantitative easing, forward guidance or fiscal stimulus. As New Keynesian pioneer Jordi Gali noted in a recent summary (goo.gl/zp7qEY), there has been much work figuring out how New Keynesian models can deal with zero interest rates. There has also been much work on making the models more realistic by taking into account the big differences among consumers and companies. These are important innovations, and they address glaring deficiencies in the pre-2008 models. But they don’t feel like a big break with the status quo. Most importantly, the basic notion of recessions as driven by rational actors’ responses to unpredictable, sudden events remains in place.
That would come as a jarring surprise to many outside academia. To lots of people, it seems obvious that the 2008 crisis was long in the making—the product of years of financial and regulatory folly. In general, the notion that economic booms cause busts, instead of being random unrelated events—an idea advanced by Hyman Minsky—seems to have much more currency beyond the ivory tower than within it. But at least a few economists are working on something more revolutionary—a new interpretation of recessions, booms and financial markets that more closely matches the popular idea that business cycles are both predictable and driven by irrationality.
The basics of this new idea are laid out in a presentation by Nicola Gennaioli and Andrei Shleifer—two behavioural finance specialists venturing into the realm of macroeconomics. Gennaioli and Shleifer take their cue from a number of recent papers hinting that recessions are actually possible to predict years in advance, if one simply pays attention to the right variables. One of these is a 2013 paper by Robin Greenwood and Samuel Hanson, showing that when junk bond issuance increases and credit spreads narrow, a credit bust often tends to follow two or three years later. Another is a 2016 paper by Matthew Baron and Wei Xiong, showing a similar result for bank lending instead of corporate bonds. Other papers find a correlation between rapid credit growth and heightened recession risk.
All of these papers have one thing in common—they use debt to predict recessions years in advance. That fits with the emerging post-crisis wisdom that problems in credit markets are the source of both financial crashes and the ensuing economic slowdowns.
Gennaioli and Shleifer explain these patterns by turning to their own preferred theory of human irrationality—the theory of extrapolative expectations. Basically, this theory holds that when asset prices rise without a break, investors start to believe that this trend represents a new normal. They pile into the asset, pumping up the price even more, and seeming to confirm the idea that the trend will never end. But when the extrapolators’ money runs out, reality sets in and a crash ensues.
When extrapolative expectations are combined with an inherently fragile financial system, a predictable cycle of booms and busts is the result. At some point during good economic times, irrational exuberance takes hold, pushing stock prices, house values, or both into the stratosphere. When they inevitably come down, banks collapse, taking the rest of the economy with them.
This story, if it became the standard model of the business cycle, would represent a true revolution in macroeconomics. It discards two pillars of recent macroeconomic thought—rational expectations, and shock-driven unpredictable recessions. It would represent a triumph for Minsky’s ideas, and for those outside the academy who have long urged macroeconomists to pay more attention to debt markets and human psychology. And if the code of booms and busts can finally be cracked, there may be ways for central banks, regulators or other policymakers to head off crises before they begin, instead of cleaning up afterward.
So far, Gennaioli and Shleifer’s story isn’t close to achieving dominance in macro. But of all the ideas being put forth in the field, this seems like the most interesting to watch. Bloomberg View
Noah Smith is a Bloomberg Opinion columnist.
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