Where modern macroeconomics is going wrong

Brian Easton

There is a slowly but steadily accumulating body of criticism of the dominant economic paradigm which constitutes today’s conventional wisdom. A recent Oxford Review of Economic Policy devoted an entire issue to critiquing ‘Dynamic Stochastic General Equilibrium’ (DSGE) models, a workhorse of econometric forecasting based on much of the current thinking. Some of the critics in the volume try to rescue these models, but the eminent economist and Nobel Prize winner Joseph Stiglitz attacked the models as so fundamentally flawed that they are irrecoverable. However, Stiglitz does not have just DSGE models in the gun but the whole of macroeconomics as it is commonly practised:

I believe that most of the core constituents of the DSGE model are … sufficiently badly flawed that they do not provide even a good starting point for constructing a good macroeconomic model. These include

(a) the theory of consumption;

(b) the theory of expectations – rational expectations and common knowledge;

(c) the theory of investment;

(d) the use of the representative agent model ….: distribution matters;

(e) the theory of financial markets and money;

(f) … excessive aggregation …

(g) shocks—the sources of perturbation to the economy; and

(h) the theory of adjustment to shocks—including hypotheses about the speed of and mechanism for adjustment to equilibrium or about out-of-equilibrium behaviour.


The attack is so extensive that it cannot be summarised in the length of this briefing. Moreover some of the criticisms are quite technical and not easily explained to lay people. Here is a selection:

  • Individuals and firms have to take into account credit constraints but this is ignored in the standard model so that neither the accounts of consumption nor investment are realistic.
  • The representative agent model doesn’t work well because some individuals are credit constrained, while others are not. It eliminates any possibility that distribution matters. Moreover, in a representative agent model, debt (held domestically) nets out, and therefore should have no role. More generally money is not the integral element of the theory many economists and those that follow them use.
  • Given that money is at the heart of the modern market economy including the Global Financial Crisis, macroeconomic analysis based on DSGE models and related approaches did not just fail to predict such disturbances – they are not designed to predict a financial crisis any more than to predict the weather – but offer very little useful analysis or policy advice.

Stiglitz’s basic point about expectations is captured by ‘analyses of expectations were (correctly, in my view) not based on what those might be if it were assumed that individuals had rational expectations, or acted as if they did, but on survey data of what expectations are and have been.’ Resorting to survey data is an admission that we do not have a useful theory to predict actual expectations or how they are formed. He rightly rejects the standard theory of ‘rational expectation’ with its precise predictions which are frequently wrong to the point of uselessness.

Aggregating the whole economy into a single sector ignores that sectors grow at different rates. (Single commodity thinking has been the bane of too much of New Zealand economic analysis.)

Stiglitz goes on that ‘monetary policy is typically presented as an efficient tool. But monetary policy has disproportionate effects on interest-sensitive sectors, thus inducing a distortion in the economy that simply is not evident in a one-sector model.’ ( One of our most interest-sensitive prices is the exchange rate.)

He writes a lot about shocks, basically attacking the popular ‘real business cycle theory’. The details of this arcane theory need not concern us. What is important is that shocks can come from within the economic system as they did to generate the Global Financial Crisis. Stiglitz also has doubts about the theory of adjustment to shocks, thinking it underestimates the time involved and the complexity.

This is a fierce attack on much of the most commonly used economic paradigm, the one that you are told is the conventional wisdom, that you hear from over-eager economists, business people, journalists and politicians, that which having failed to predict or even countenance the GFC, was used to justify the austerity policies which followed it in many parts of the world. After Stiglitz’s criticism it is no surprise these models have not worked in their own terms (that is, ignoring the ideological agenda which pervades them).

Critically the attack is entirely from within economic theory. Almost all of Stiglitz’s criticisms of assumptions which are not robust, were well-known shortly after the flowering of the earliest developments in the underlying theory, and were once routinely taught to economics students.

Sadly today they often are not taught; even when they were, most economists seem to have forgotten them. Instead these critical assumptions have been ignored in the main analysis of their economic paradigm without the caveats which weaken the robustness of the model, the forecasts and the policy advice it favours. Stiglitz is much too eminent an economist in the profession – he is not a Keynes but is up there – to be described as ‘unorthodox’. Fundamentally, he is calling for a ‘back to basics’. It will be interesting to see how many economists can redirect their thinking. Business people, journalists and politicians – and therefore policy – will follow, probably with a very long lag. It is going to be hard to break away from austerity-oriented policies.

Stiglitz’s criticisms in this paper are concerned only with macroeconomics but there are hints that he has similar doubts about other parts of economics such as its dependence upon ‘rational economic man’. As Nobel Prize winner Paul Krugman (who also presents a critique in the Oxford Review of Economic Policy volume) tweeted in response to Richard Thaler being awarded the 2017 Nobel, ‘Yes! Behavorial econ is the best thing to happen to the field in generations, and Thaler showed the way.’ Sadly the indications are that too many economists and others will cling to the old model despite being inconsistent with the evidence, because it is all they know. And not just in the economics of decision-making.

Following economics is currently exciting if you like intellectual challenges. But it is not for the faint-hearted, nor is it for those who would go outside ‘orthodox’ economic theory without a grasp of what actually constitutes it. Ultimately Stiglitz, Krugman, Thaler and many other critics are more orthodox than the superficial theories they are criticising.

What this means for policy is unclear. The wise politician (if that is not an oxymoron) will want a diversity of advice and will ensure that the advice system does not ignore orthodox economists who challenge the conventional wisdom.

Categories: Economic policy
Brian Easton
About the author

Brian Easton

Brian Easton is one of New Zealand’s leading economists with a unique profile as an economic development practitioner, consultant, journalist and commentator. A former director of the New Zealand Institute of Economic Research and a one-time member of the Prime Minister’s Growth and Innovation Advisory Board Brian has numerous awards to his credit including being a distinguished Fellow of the New Zealand Association of Economists. Dr. Easton is an adjunct Professor of the Auckland University of Technology and is currently writing a history of New Zealand from an economic perspective, Not In Narrow Seas: A Political Economy of New Zealand’s History, to be published by Massey University Press.