21st century crises, from the global financial crisis to COVID, demand new economic understanding, say top economists

19 January 2021

Leading economists, including Nobel Laureate Joseph Stiglitz, Argentina's Minister of Economy Martin Guzman, and academics from Oxford, Yale, Columbia, and UCLA, are today calling for a deep shift in how economists understand the overall, or ‘macro’ economy.

They believe a series of massive economic shocks have left traditional economic theory in pieces and that a new, more promising economic paradigm is starting to emerge.

Oxford economics Professor David Vines says, ‘The old model of macroeconomics was built for a stable world free from large economic shocks. If we ever lived in such a world, we no longer do.’

These economists have come together in the Rebuilding Macroeconomic Theory Project, and today’s issue of the Oxford Review of Economic Policy (OxREP) collects their work.

Introducing the issue, Professor Vines and Dr Samuel Wills herald a shift away from the assumptions which have underpinned economic theory for decades. They outline the new, more open, more diverse paradigm that is emerging – one which, they argue, is far better equipped to deal with contemporary economic challenges such as global financial crises, Covid and climate emergencies.

Professor Vines says, ‘An economic model that cannot handle serious shocks is like a medical science that does not study major disease outbreaks; it is likely to let us down at the most critical of moments. The old economic model has already failed us badly in the 21st century.’

Hardly any macroeconomists saw the 2008 global financial crisis coming. Macroeconomics’ reputation was dragged down further by the slow and weak recovery from that crisis, which many observers now agree was made much worse by the world-wide policies of austerity.

Contributions to today’s journal issue, Professor Vines and Dr Wills argue, show how the old macroeconomic paradigm is being replaced by a new approach which is less tied to idealised theoretical assumptions, takes real-world data much more seriously, and is, therefore, far better suited to dealing with 21st century challenges.
Dr Wills says, ‘This shift breaks with more than a century of macroeconomic thought and has wide-ranging implications for economic thought and practice.’

What is wrong with the old macroeconomic paradigm?
Macroeconomics has been dominated by one core approach for the last two decades: the ‘New Keynesian Dynamic Stochastic General Equilibrium’ (NK-DSGE) model. While this remains the generally accepted framework, contributors to this issue of OxREP argue it is no longer fit for purpose for two main reasons:

  1. It is unsuited to understanding large economic shocks
    At the heart of the old model is the assumption that, after any shock, the economy eventually returns to one stable ‘equilibrium’ in which it continues to grow. This assumption makes the model badly suited to studying major crises, where feedback loops can prompt unemployment to skyrocket, financial systems to seize up, or population health to collapse.
    Since large shocks are the economic phenomenon with the deepest and most wide-reaching implications for our lives, this is exactly when good economic advice and policymaking are most needed.
    Professor David Vines says, ‘The standard assumption that the economy returns to just one equilibrium point is a major diversion from reality. If we want an economics which faces up to the challenges of the 21st century, it is crucial for the discipline to understand the possibility of multiple economic equilibria.’
  2. It is built on over-idealised foundations
    The old model is built on a set of assumptions about how people act in the economy and why: it assumes people are always perfectly informed, rational, and dedicate all their attention and effort towards one goal.
    As Dr Wills says, ‘This analytical straight-jacket means the old paradigm refuses to recognise that we all act under uncertainty about the future when we make economic decisions, and that our decisions are, therefore, always shaped by our best guesses, habits, and rules of thumb.’

How is the new economic paradigm different? 
The new macroeconomic paradigm studies how multiple economic equilibria can arise in response to major crises, and uses a wide range of different kinds of economic models to find the best policy responses to such shocks. Contributors to this issue of OxREP explain why a range of models is needed and what they can be used for. 

Professor Vines and Dr Wills call this new paradigm, ‘MEADE’: ‘Multiple Equilibrium and DiversE’ (in recognition of the work of Nobel prize-winning economist James Meade).

Professor Vines says, ‘The MEADE paradigm has far deeper roots in the real world than the old macroeconomic approach: it stresses the need for models based on detailed empirical understandings of how the economy actually is, rather than how it theoretically should be.

‘Just as doctors only build up a full understanding of how a body is functioning using a whole host of empirically-grounded diagnostic tools, so must economists build up a full understanding of how economies function using a wide range of empirically grounded tools and models.

‘Placing too much weight on the old, overly-idealised model has blinkered macroeconomics; the blinkers are now coming off, and we want to speed this change.’

Notes to editors: 

For further information please contact Jessica Kaplan, INET Oxford Communications Manager: Jessica.Kaplan@inet.ox.ac.uk / +44 7956 641 829. The Institute for New Economic Thinking at the Oxford Martin School (INET Oxford) applies leading-edge thinking from the social and physical sciences to major economic and social challenges.

  • Professor David Vines is Emeritus Professor of Economics and Emeritus Fellow of Balliol College at the University of Oxford and Director of the Ethics and Economics Programme at INET Oxford. He is also a Research Fellow of the Centre for Economic Policy Research. He was previously Adam Smith Professor of Political Economy at the University of Glasgow.
  • Dr Samuel Wills is an external research associate at the Oxford Centre for the Analysis of Resource Rich Economies at the University of Oxford, as well as in the School of Economics at the University of Sydney and at the Centre for Applied Macroeconomic Analysis at ANU. 
  • The full OxREP issue of the Rebuilding Macroeconomic Theory project, including articles by Joseph Stiglitz, Martin Guzman and others, can be viewed here 
  • The assumption that the economy eventually returns to one stable ‘equilibrium’ makes the old model unsuited to large shocks because the feedback loops generated by such shocks can stabilise at many different possible endpoints. While the economy might emerge out of a crisis and stabilise in a healthy economic state it might also stabilise in a bad state, with very bad outcomes, or at any number of points in between. Economists name this many-possible-outcomes prospect ‘multiple equilibria’. 
  • Nobel Laureate James Meade worked with Keynes in the 1930s and 1940s, was Vines’s mentor at the University of Cambridge in the 1970s and 1980s, and was intimately connected with macroeconomic policymaking in the United Kingdom for over 50 years.
  • The new MEADE paradigm does not exclude the NK-DSGE model but instead incorporates it in a wider, more diverse framework. 
  • In the first issue of the Oxford Review of Economic Policy devoted to the Rebuilding Macroeconomic Theory project (published in 2018), the contributors, including Joseph Stiglitz, Paul Krugman, David Vines, Samuel Wills and others, agreed that the NK-DGSE model’s poor performance over the past decade could not justify its position as macroeconomics’ core model. But the group then thought that certain updates to the old model, along with a more diverse disciplinary approach, might be enough of a remedy. The Coronavirus crisis led Vines, Wills, and many other contributors to change their minds for this second issue of the Oxford Review of Economic Policy on the Rebuilding Macroeconomic Theory project.

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