Few Saw the 2007-08 Crisis Coming Because Most DSGE Models Exclude Key Variables Like Loose Credit

Since the mid-1950s, macroeconomic theorizing evolved from what has been aptly called ‘hydraulic Keynesianism’ into dynamic stochastic general equilibrium (DSGE) models of the economy. In the process, this type of theorizing has come to dominate mainstream economics, absorbing both Keynesians and neoclassicals within the same methodological paradigm. Neoclassicals insist that changes in monetary conditions can have no effect on real outcomes, whereas Keynesians invoke ‘price stickiness’ and other rigidities to come to different conclusions.

Despite longstanding and convincing objections to the DSGE model, on the eve of the financial crisis of 2007–08 it commanded almost universal support within the mainstream of the economics profession. The unquestioning nature of this support has been compared by Roger Koppl to John Stuart Mill’s endorsement of the cost-of-production theory of value shortly before its overturning by the marginalist revolution in the last quarter of the nineteenth century.

The credibility of mainstream macroeconomic thinking has been fatally undermined, not yet by an alternative theory but by its inability to explain either the proximate or the underlying causes of the crisis of 2007–08. Nor has it been able to offer any explanation for the unexpected duration of the subsequent recession. It is widely acknowledged that the proximate cause of the financial crisis was a loss of confidence on the part of some major financial intermediaries in the ability of counterparties to meet their obligations. Hence the ‘credit crunch’ by which this loss of confidence was transmitted to the real economy.

The more fundamental origins of the crisis are to be found in the loose credit and regulatory policies that were pursued in earlier years, permitting an unsustainable boom in house and other asset prices. Neither of these factors appears among the list of variables specified in most DSGE models, so it is not surprising that few academics or policymakers ‘saw the crisis coming’.

—David Simpson, “What’s Wrong with Keynesian Economics?” in What’s Wrong with Keynesian Economic Theory? ed. Steven Kates (Cheltenham, UK: Edward Elgar Publishing, 2016), 203.