Towards a General Theory of Deep Downturns: Presidential Address from the 17th World Congress of the International Economic Association in 2014

The world has been plagued by episodic deep downturns. The crisis that began in 2008 in the United States was the most recent, the deepest, and longest in three quarters of a century. It came despite alleged “better” knowledge of how our economic system works, and belief among many that we had put economic fluctuations behind us. Our economic leaders touted the achievement of the Great Moderation.¹ As it turned out, belief in those models actually contributed to the crisis. It was the assumption that markets were efficient and self-regulating and that economic actors had the ability and incentives to manage their own risks that had led to the belief that self-regulation was all that was required to ensure that the financial system worked well, and that there was no need to worry about a bubble. The idea that the economy could, through diversification, effectively eliminate risk contributed to complacency — even after it was evident that there had been a bubble. Indeed, even after the bubble broke, Bernanke could boast that the risks were contained.² These beliefs were supported by (pre-crisis) DSGE models — models that may have done well in more normal times, but had little to say about crises. Of course, almost any “decent” model would do reasonably well in normal times.

This chapter, an extension of the Presidential Address to the International Economic Association, evaluates alternative strands of macroeconomics in terms of the three basic questions posed by deep downturns: What is the source of large perturbations? How can we explain the magnitude of volatility? How do we explain persistence?.

This chapter argues that while real business cycles and New Keynesian theories with nominal rigidities may help explain certain historical episodes, alternative strands of New Keynesian economics focusing on financial market imperfections, credit, and real rigidities provide a more convincing interpretation of deep downturns, such as the Great Depression and the Great Recession, giving a more plausible explanation of the origins of downturns, their depth and duration.

Since excessive credit expansions have preceded many deep downturns, particularly important is an understanding of finance, the credit creation process and banking, which in a modern economy are markedly different from the way envisioned in more traditional models.

The 2008 crisis was not only a crisis in the economy, but was also a crisis for economics — or at least that should have been the case. As we have noted, the standard models did not do very well. The criticism is not just that the models did not anticipate or predict the crisis (even shortly before it occurred); they did not contemplate the possibility of a crisis, or at least a crisis of this sort. Because markets were supposed to be efficient, there were not supposed to be bubbles. The shocks to the economy were supposed to be exogenous: this one was created by the market itself. Thus, the standard model said the crisis could not or would not happen; and the standard model had no insights into what generated it.