Prof. George Akerlof (2001 Nobel) shows how macroeconomics overlooked the issue of financial stability as a pillar. He argues that Rajan’s 2005 paper and talk were uniquely prescient on this.
This is why we find thinking about, say, the Panic of 1873 so instructive especially when one adds an “omnidirectional” analysis: In 1873, we get Around the World in Eighty Days with the transport revolutions that make winning this bet about circling the world in eighty days, at all possible: railroads, steamships, etc. London is shown to have emerged as the world money center, as described in Walter Bagehot’s classic Lombard Street. The opening line of The Magnificent Ambersons is (in paraphrase): “The financial crisis of 1873 destroyed the fortunes of most people but made the Ambersons and this was the basis of their magnificence.”
The novel The Age of Innocence by Edith Wharton, set in the 1870s, shows the financial shocks of 1873 as a major player in the story.
Prof. Adam Tooze of Columbia published in 2018 a masterful account of finance and macro and politics relevant to our 2008 fiasco in his Crashed:
Crashed: How a Decade of Financial Crises Changed the World
Hence Akerlof’s depiction, in the current Journal of Economic Perspectives, of how macroeconomics became separated from financial instability analyses is key:
“The Keynesian–neoclassical synthesis that had emerged by the early 1960s put constraints on macroeconomics. Foremost, it divorced macroeconomists from working on financial stability. Luckily, after the crash of 2008, the prior work of finance economists has been belatedly acknowledged, and the subfield of macro stability has also emerged as quite possibly the most vibrant research frontier in economics. Nevertheless, macroprudential concerns remain as back matter in the textbooks. Correspondingly, macroprudential policy is undervalued in the councils of government. Yet its importance remains, given the likelihood of another crash.”
In this context, little damage could be done by macro models lacking the details of the financial system. But exclusion of such detail (with the attendant possibility of financial crash) from standard macroeconomics could be a problem in a different context: if the financial system changed in fundamental ways. That was exactly the topic of Rajan’s (2005) Jackson Hole talk, “Has Financial Development Made the World Riskier?” [PDF] which did predict the crash of 2008 as it actually happened. In terms of the skeletal model, had that “financial development” beyond a well-supervised banking system with deposit insurance driven the financial system out of the safe region of always hold? In September 2008, the answer to Rajan’s question became clear: “yes, it had.”
Journal of Economic Perspectives—Volume 33, Number 4—Fall 2019—Pages 171–186
What They Were Thinking Then: The Consequences for Macroeconomics during the Past 60 Years [PDF] by Prof. George Akerlof.