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  A Short History of Neoclassical Business Cycles: Part III

  By James Annable | Jul 23, 2021

  As promised, this post illustrates the need to break away from friction-augmented general-market-equilibrium modeling, making room for policy-relevant macroeconomics. It reprints a Blog essay (October 28, 2016) that unsparingly reveals the uselessness of mainstream New Keynesian explanation of the 2007-09 Great Recession, the most perilous mass market failure since the 1930s depression. The analysis features the academy’s go-to market-centric DSGE modeling (rooted in the consensus FGME theory) and was published in the respected Journal of Economic Perspectives in 2010.

  “Bob Hall (2010), a former colleague of mine at MIT, is one of the first of the handful of mainstream theorists who stepped up and examined the Great Recession using ‘a simple macro model that captures the most important features of modern models.’ He emphasizes ‘realistic increases in financial frictions that… generate declines in real GDP and employment of the magnitude that occurred.’ His analysis of real-shock macrodynamics provides a benchmark contrast to the GEM Project’s explanation of the huge 2008-09 welfare loss that focuses on the micro-coherent interaction of collapsing nominal demand and meaningful wage rigidity (MWR).

  “Financial frictions. From Hall: ‘The dominant view among macroeconomists today is that a financial crisis causes real economic activity to collapse by raising frictions.’ His candidate friction for 2008-09 is measured by the jump in the spread between the Baa corporate bond and the 10-year Treasury note. The friction itself is rooted in well-known financial agency costs, featuring information asymmetries. After the Lehman bankruptcy, such costs helped push up the spread by more than four hundred basis points. Standard dynamic general equilibrium simulation tools were used to size macro implications of the higher cost of capital.

  “Model problems. Debilitating problems plague the capital-cost story. To begin, it is broadly understood that financial frictions, by themselves, cannot explain much cyclical behavior. From Hall: ‘…research generally shows that in standard neoclassical models, with normal preferences and technology and competitive markets, [financial-friction] shifts of realistic magnitude fail to deliver anything like the volatility...

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