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What causes financial crises? Unfortunately, as I wrote elsewhere (see here), mainstream macroeconomists have very little to say about the subject, given their decision to ignore the role of money, credit and finance. This error has a long history that can be traced back to the works of Adam Smith, Jean Baptiste Say and John Stuart Mill.

In its current incarnation, money is treated as a “veil” over the real economy and is thus viewed as irrelevant based on the belief that it is a commodity and banks are only intermediaries between savers and borrowers. However, as the Bank of England (2014) and others have recognized, this view is factually incorrect. In the real world, banks create credit (and, given double-entry bookkeeping, deposits, which are money).

As a result of this error, mainstream macroeconomics (as espoused by Krugman, Bernanke, et al.) did not anticipate the crisis in 2008. Here is a disturbing comment issued by Robert Lucas, a Nobel Prize winner and former president of the American Economics Association in defense of mainstream macroeconomic models in The Economist Magazine in 2009:

The charge is that the forecasting model failed to predict the events of September 2008. Yet the simulations were not presented as assurance that no crisis would occur, but as a forecast of what could be expected conditional on a crisis not occurring.

Andrew Haldane, with the Bank of England, responded that:

This is no defense. Economics is important because of the social costs of extreme events. Economic policy matters precisely because of these events. If our models are silent about these events, this jeopardizes the very thing that makes economics interesting and economic policy important.