Mainstream economic theory is under crossfire. It is not possible to analyze the crisis using the existing models: those models do not include the financial system, neglect the possibility of not repaying the debt and they do not even contain monetary system. Furthermore, these models assume that people have an extraordinary set of information and the capacity to process that information. What is more, they know how the economy operates. In short, the 'people' assumed in the model have excellent mental abilities; they can comprehend anything.

These assumptions received a number of criticisms in recent years. For instance, studies in the field of psychology and neurology indicate that the comprehension capacity of human beings is not as assumed in these economic models. Research by Kahneman, who won 2002 Nobel Prize in Economics, is an example of such studies. On Monday I wrote a piece on the latest developments regarding the macroeconomic theory and said that I will return to this issue. Today, I would like to take a brief look at how this highly criticized theory was born.

Macroeconomic models to analyze economies were different in the past. They divided the economy into sectors. Then, decisions of the economic units in these sectors and relation of these decisions with each other were tried to be modeled. At the first phase of these efforts, it would be decided what the movements in consumption, investment, national income, export and import, current account deficit, inflation, deposits and credits, interest rate and exchange rate depended on; in line with the size of the model.

After this, data for these variables as well as the variables that affect the former but does not intend to explain the changes within the model (for instance oil prices or interest rates in developed countries) were found for a quite long time period. Using certain statistical methods, equations that define the changes in those variables in time were formulated (for example, level of consumption at a certain time period equals 0.5 times of income, 0.5 times of taxes plus 0.8 times of the real value of consumer loans). After this phase, a number of equations of this type (the model) were run and two basic analyses were made. First, it was figured out how changes in economic policy, for instance a rise in tax rates, affect the variables that try to explain the changes in each equation in the model. And second, it made future forecasts.

This approach was bombarded with criticisms increasingly by 1970s.  One of the main criticisms was that the equations explaining the changes in the examined variables were arbitrarily constructed. However, equations seeking to explain the behaviors of economic agents should have reflected the decisions economic actors would make using all the information at hand and knowing how the economy works. For instance, consumers were expected to behave in a way that will maximize the interest rate starting from today until the end of their life. Thus, the models should have included this behavior style.

Another main point of criticism was the way old models address the expectations of economic units. For instance, prospective inflationary expectation is an important variable; it affects a number of consumer decisions including that on how much to consume or how much to invest. Old models (let me proceed with the inflation example again), assumed that expectations for the future level of inflation were formed in line with the inflation levels in the past. The obvious deficiency here was that inflation rates in the past were a result of the old structure (policies). However, that structure could have changed soon. On the other hand, such an expectation formation mechanism implied that economic units did not learn lessons from the past and insisted on the same mistakes.

The two main criticisms given above gave way to the 'rational expectations' revolution, which then paved the way for new models. 'Dynamic Stochastic General Equilibrium' (DSGE) models were developed afterwards. The interesting art is that, old-fashion models were developed by the followers of famous economist Keynes, and were called Keynesians. Criticisms for Keynesian models, as roughly given above, gave way to the new type of models. However, economists known as 'Neo-Keynesians' also embraced these methods without changing the core but just adding price rigidities to the model. We will continue with these models bombarded with criticisms after the global crisis. I will continue with this.

This commentary was published in Radikal daily on 27.12.2009