Hard Times for Dr Pangloss

High and persistent unemployment, over-indebtedness and financial instability, bankruptcies, domino effects and the spreading of systemic risk: these phenomena have taken center stage in light of the Global Financial Crisis.

By construction, the Neoclassical approach is much better suited to study the features of the world of Dr Pangloss (Buiter, 1980) than the intricacies of a complex, financially sophisticated economy. This point is well taken in the introduction of a seminal paper by Bernanke, Gertler and Gilchrist published well before the Global Financial Crisis: ‘How does one go about incorporating financial distress and similar concepts into macroeconomics? While it seems that there has always been an empirical case for including credit-market factors in the mainstream model, early writers found it difficult to bring such apparently diverse and chaotic phenomena into their formal analyses. As a result, advocacy of a role for these factors in aggregate dynamics fell for the most part to economists outside the US academic mainstream, such as Hyman Minsky, and to some forecasters and financial market practitioners.’ (Bernanke et al., 1999, p. 1344).

This candid admission by three of the most distinguished macroeconomics (one of them destined to be Chairman of the Federal Reserve for eight long and turbulent years) – which, incidentally, provides a long overdue implicit tribute to Hyman Minsky – also provides the research question for a model of the financial accelerator which has started a non-negligible body of literature in contemporary macroeconomics.

In order to put this development in macroeconomic thinking into context, it is necessary to recall that any mainstream macroeconomic model is based on a Dynamic Stochastic General Equilibrium (DSGE) skeleton, which can support either a Real Business Cycle (RBC) model or a New Keynesian (NK) model.

The latter differs from the former because of the presence of imperfections, the most important being imperfect competition and nominal rigidity. The structural form of the standard NK-DSGE framework boils down to a threeequation model consisting of an optimising IS equation, an NK Phillips curve and a monetary policy rule based on changes in the interest rate.

The NK-DSGE framework is, of course, too simple and therefore inadequate to analyse the emergence of a financial crisis and a major recession for the very good reason that neither asset prices nor measures of agents, financial fragility show up anywhere in the model.