Your Elites Are Like A Parasite About To Kill Its Host

oxforduniversitypress |  At the centre of the modern theory of credit rationing, as observed at the macro level, are banks—a critical institution which was missing from DSGE models. This was a particularly peculiar omission because, without banks, there presumably would be no central banks, and it is the central bank’s conduct of monetary policy that is central in those models. The fact that credit is allocated by institutions (banks), rather than through conventional markets (auctions) is an important distinction lost in the DSGE framework. Greenwald and Stiglitz (2003) model banks as firms, which take others’ capital, in combination with their own, obtaining and processing information, making decisions about which loans to make. They too are by and large equity constrained, but in addition face a large number of regulatory constraints. Shocks to their balance sheets, changes in the available set of loans and their expectations about returns, and alterations in regulations lead to large changes in loan supply and the terms at which loans are made available. Variations in regulations and circumstances of banks across states in the US are helping validate the importance of variation in the supply conditions in banking in the 2008 crisis and its aftermath.³⁸

Given how long it takes balance sheets to be restored when confronted with a shock of the size of that of 2008, it is not surprising that the effects persisted.³⁹ But they seem to have persisted even after the restoration of bank and firm balance sheets. That suggests that this crisis (like the Great Depression) is more than a balance sheet crisis. It is part of a structural transformation, in the advanced countries, the most notable aspects of which are a shift from manufacturing to a service-sector economy and an outsourcing of unskilled production to emerging markets; for developing countries, the structural transformation involves industrialization and globalization. Not surprisingly, such structural transformations have large macroeconomic consequences and are an essential part of growth processes. DSGE models are particularly unsuited to address their implications for several reasons: (a) the assumption of rational expectations, and even more importantly, common knowledge, might be relevant in the context of understanding fluctuations and growth in an agricultural environment with well-defined weather shocks described by a stationary distribution,⁴⁰ but it cannot describe changes, like these, that happen rarely;⁴¹ (b) studying these changes requires at least a two-sector model; and (c) a key market failure is the free mobility of resources, especially labour, across sectors. Again, simple models have been constructed investigating how structural transformation can lead to a persistent high level of unemployment, and how, even then, standard Keynesian policies can restore full employment, but by contrast, increasing wage flexibility can increase unemployment (see Delli Gatti et al., 2012a,b).