Macroeconomics has really, really, really dropped the ball

Matt Yglesias puts the idea of a recession in startlingly simple terms:

We have lots of people now with the ability to do useful work and the desire to do useful work, but nobody will pay them to do anything. And we have lots of tools and machinery with the ability to do things that aren’t being used because there aren’t enough employed workers to use them all. We haven’t lost the capacity to do stuff, but we aren’t doing as much stuff.

Quite right. Nothing has reduced the economy's stock of physical assets or skilled labor or technology, but those assets are not being put to use, because something is messed up in the economic transmission mechanism that matches buyers with sellers. The transmission mechanism that as been messed up is the financial system.

Now, when I think of this obvious and startlingly simple fact, I get mad, because I know something that not a lot of people know: namely, that economists have not devoted a lot of time to studying financial crises. There are notable exceptions: Kenneth Rogoff, for instance. But they are few and far between, and have come relatively recently in the history of the profession. Instead, for decades, economists spent their time making models of recessions that had nothing whatsoever to do with financial systems - even though financial crises are clearly associated with almost every big severe recession in history. Financial crises are obviously - excuse the pun - where the money's at.

And for those who are unfamiliar with the economics profession, consider this: the dominant theory of the business cycle is called "Real Business Cycle," or "RBC" theory. This theory holds that business cycles are caused by improvements or reductions in the level of technology - businesses and consumers are just optimally reacting to the technology they have available, and government and the Fed are essentially irrelevant. When a boom happens, it's because technology improved. When a recession occurs, it's because our technology got worse (?!!!), or at least wasn't as good as we had expected it to be. "Transmission mechanisms" like the financial system have nothing to do with it; they're assumed to always work perfectly. The man who came up with this ridiculous exercise in useless intellectual self-abuse brilliant and revolutionary theory was none other than Edward Prescott - he of the famous "drunk economist emails", pictured above. He won a Nobel Prize for it. In 2004.

In any case, for at least two decades, probably more, we have thus been assuming that recessions merely fall randomly from the sky, or (according to the main alternative to RBC theory) are caused by the Fed's mistakes. Nowhere is there a mainstream, well-accepted theory of recessions that are caused by breakdowns in the financial system. And yet, it is very difficult for a sane, normal person of reasonable intelligence to look at the world and not believe that financial breakdowns cause deep, long recessions. What gives?

If physicists made theories that said apples fall upward, they'd be laughed out of town. With economics, we apparently have to wait half a century just to find out that apples, in fact, fall toward the Earth.