One of the puzzles that accompany this gruelling economic crisis is why neo-liberal economic thinking, which when applied caused the crisis and has delivered very little to so many, remains the dominant paradigm in economic policy making and has managed to turn a disaster for practitioners of that ideology into a triumph. How is it that the leading voices now are preaching exactly the same policies that caused the crisis as the solution to the crisis. Is there that much asymmetry? I noted a recent comment on my blog (Tom) that raised issues relating to the philosophy of science along the lines of how are we to judge whether the mainstream macroeconomics paradigm has failed. I understand the demarcation issues involved and the problems of “truth testing”. But we can take a more simple approach to the question. Here are two ways we know that the mainstream approach failed – they didn’t have a clue what was happening in the years leading up to the crisis and now they are scrambling in a stunned state to add banks and financial markets to their defective models. The problem is that they are just building more defective approaches. But the continued dominance demonstrates that their failures are not yet fully understood.

It is unsurprising that my profession has suddenly became enamoured with studies of financial cycles. Up until the GFC mainstream macroeconomics (theories and models) mostly ignored financial markets and banking, thinking that they were largely peripheral to understanding the business cycle. The only linkage between the financial sector and the real economy that was considered was via interest rates – the impact on investment spending and the demand for loanable funds to fund investment impacting back onto interest rates. Even within this limited context, the theories developed were hopelessly deficient and incapable of explaining anything that relates to the real economy. But now – more brash than ever – my profession is busily conjuring up financial markets to fit into their Dynamic Stochastic General Equilibrium (DSGE) models, despite these models being next to useless. In March 2009, Willem Buiter said that DSGE models “excludes everything relevant to the pursuit of financial stability.” More recent research from the BIS (link below in the text) has highlighted some salient facts about the relationship between financial cycles and business cycles. What that research implies is that push for fiscal austerity is without foundation and will not only damage the real economy but will, in the process, prolong the financial downturn and prevent a resolution that could provide the springboard for sustainable growth.