This failure, though, is part of a wider and longer omission - it is not a mere quirk of DSGE models. Macroeconomics has traditionally ignored the inner workings of all companies. It has seen non-financial firms as mere production functions, transforming inputs into output in a stable (and smoothly differentiable) way. Regarding banks as black boxes for converting savings into loans is a natural consequence of paying insufficient heed to institutions.
However, we can only understand this crisis by looking inside the black boxes. We can do so from two perspectives.
One is the Austrian angle, which stresses the role of entrepreneurship, of discontinuous innovation. But this played a crucial role in the crisis. Banks used new mortgage derivatives as collateral to raise wholesale funds. This had the effect - we now know! - of increasing the riskiness of that funding. Macroeconomists’ natural tendency to assume stable production functions distracted them (us) from the consequences of this innovation.
The second perspective is that of principal-agent problems.
It is only in this context that criticisms about banks’ handling of risk makes sense. Intellectually, everyone has known about tail risk, correlation risk, liquidity risk and counterparty risk for years; the crash of 1987 and the collapse of LTCM in 1998 taught us all about them.
The problem is, though, that agency problems within banks militated against understanding these risks.
For example, who is most likely to keep his job as risk manager - the guy who tells his board “our value at risk today is £112.5m” or the guy who says “we dunno the default risk on our CDOs because we haven’t enough data. It’s really hard to quantify correlation risk or counterparty risk and the maths of non-Gaussian copulas is really tricky”?
The fact is that people in power very often want precise answers, not true ones - especially when it‘s only other people‘s money they are managing. Offering precision rather than truth is therefore a trick one can use to climb up the greasy pole.
Or take another example. Which trader is going to get more capital and more autonomy from his bosses - the one who says “these assets are mis-priced: we can make a fortune here”, or the one who says: “these look cheap, but they carry all sorts of liquidity, tail, correlation and counterparty risks”?
It’s agency problems, then, that help us understand why banks behaved as if they were really moronic.
Again, mainstream macro’s “black box” mentality led it astray. Economists listened to Taleb railing against the risk management and said - rightly - “no-one’s that stupid.” But they (we) failed to consider that institutions can be structured so as to filter out intelligence.
In other words, macroeconomics failed in this crisis because it has for ages under-rated the importance of the stuff we (might) learn in industrial organization classes.
Herein, though, lies a quirk of history. There’s one significant figure who cautioned against this error - Marx. In Capital (ch 6) he criticized orthodox economists for ignoring “the hidden abode of production.”
But mainstream economists - including Keynes - ignored him. They did so, in large part, because they were not especially interested in Marx’s question of how income was distributed between profits and wages.
So, could it be that a by-product of a lack of interest in this question has been “black box” thinking that’s proven very costly for mainstream economics? The amazing thing is that macroeconomics managed so well for so long with this omission.