The next big idea of macroeconomics: Linking human psychology with debt markets?

Noah Smith in this piece wonders how come the 2008 crisis has not led to any new  thinking/development in macroeconomics.

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.

For instance this paper by Jordi Galli says New Keynesian Macro, which was the dominant framework before crisis, is working fine even post-crisis with modifications.

Smith points to this paper (slides discussed in Nobel Symposium as well) by Pedero Bordalo, Nicola Gennaoli, and Andrei Shleifer which could be the next big thing to look at in macro:

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

Not sure how different this is from Kindleberger’s work on Manias, Panics and Crashes. Even Shiller has said the same things…


One Response to “The next big idea of macroeconomics: Linking human psychology with debt markets?”

  1. anushsridhar Says:

    The rise of behavioural finance has come as a reaction to the increase in the magnitude of stock market rallies and crashes, to explain price movements when the efficient market hypothesis fails to do so. Richard Thaler spoke of ‘the end of behavioural finance’ (, because what other kind of finance is there?

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