The 2008 financial crisis of the US was a watershed for economics discipline, especially macroeconomics. Several world leaders such as the Queen of England questioned distinguished economists of Ivey league schools such as the London School of Economics on why they failed to see what was happening and had not prevented the crisis through policy advice? Most did not have an answer. Why? One of the reasons is the supply side economics, which is also called Monetarism; and the Chicago School of Economics, which advocates that free markets function efficiently and self-regulate; and at best governments should tinker with monetary policy of money supply; has become the dominant intellectual basis for policy making for the last forty years. Models of this kind failed to predict the financial crisis because they are based on strong assumptions.
The lesson from the financial crisis is that macroeconomic models have to incorporate financial markets and account for asymmetric information, transaction costs and moral hazard behaviour of economic agents. Governments have to regulate especially the financial markets. Free market fundamentalist will ask the question as to why one should expect the government agents to do a better job than private agents because they are also subject to moral hazard behaviour of using tax payers’ money. One answer to this is that if a large number of private agents act autonomously, the sum of average transaction and information costs of markets is higher than if one large agent pools these costs and realizes economies of scale. Government does this job- the tax collected from each agent could be lower than the average information and transaction costs of private agents. As far as the moral hazard behaviour of government agents is concerned, it is a political economy issue of designing and implementing institutions.
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