A couple of weeks ago Martin Wolf blogged on the way in which modern macroeconomics has neglected the explicit and integrated treatment of the financial sector. The consequences of this omission have turned out to be of enormous practical significance. It left analysis mostly blind to a range of important real world developments. He provided a brief summary of the characteristics of the banking system that he considers economics students need to be familiar with.

This is a theme developed by Professor Wendy Carlin in the revision of her textbook currently under development. She blogged about the aim of the project a year ago. The revision seeks to move instruction beyond a three equation model which does not explicitly incorporate money or credit. The approach retains that three equation model at its heart, but grafts on to it a financial sector that is, rather than a gross simplification, relatively rich in institutional detail. The motivation is that the model needs to be able to explain how changes in financial markets shifted and intensified risk in ways that ultimately precipitated the financial crisis and the subsequent macroeconomic turbulence.

It strikes me that this is an important project. Rather than leaving consideration of the impact of a highly developed financial system to more esoteric later study – if it is ever studied at all – it starts students off with an appreciation of the fundamental significance of finance for the functioning of the macroeconomy.

Professor Carlin came to Bristol earlier this week to give a presentation on her finance-augmented macro model. The approach has several distinctive components. At its centre is the attempt to account endogenously for cycles of different periodicity, including a long wave financial cycle. The model invokes positive feedback mechanisms in both the banking and real estate/housing sectors to generate cycles and bubbles. The point here is that while the two sectors may work in concert to reinforce volatility they are distinct and separable. The explanation works through rising asset valuations lifting credit constraints and therefore inducing increased leverage. There is also an argument about the way in which, as the market starts to move, risk-averse households and risk-neutral investors interact in a way that results in risk concentrating in the financial sector.

I look forward to getting my hands on the book itself when it emerges to see how these arguments play out a greater length. But a couple of things struck me from this week’s presentation.

There was the suggestion that risk was accumulating pre-2007 without macroeconomists recognizing it. I think that sort of statement needs qualifying. Academic macroeconomists may well have been blinkered by a reliance on money-free DSGE models and an aversion to primary research. But as we came closer to those who were observing what was going on – such as economists at the Bank of International Settlements – you could detect in reports being produced in the early and mid-2000s the warning being sounded about the increasing fragility of the financial system.

Professor Carlin emphasized that the economic cycles experienced by different countries look very different. It is very hard to draw general, institution-free conclusions about the way in which the macroeconomy and financial system interact. That is a vital, and profound, point. An adequate appreciation of the behaviour of the economy requires greater appreciation of the institutional context. This contrasts with textbook treatments that suggest we are acquiring analytical insights that can be unproblematically transferred across contexts. Carlin’s approach suggests that there are general lessons, but they are of a qualitatively different type.

However, I am more cautious about the reliance on differing risk preferences and the relaxation of credit constraints to explain the run up in leverage. It could be taken to suggest that there was something inevitable and, perhaps, unavoidable about this, within a given institutional framework. But as every day goes by and a new example of dubious or unlawful behaviour by financial institutions – collusion, rate fixing, misselling, market cornering – emerging we have to recognise that there were other things going on. The intersection between ethics and institutions is fundamental. And macroeconomics has yet to wrestle with the implications.

As someone who spends more time thinking about housing markets than the macroeconomy, I am pleased to see that the housing market features prominently in the analysis. But a couple of points sprang to mind.

The first is that credit constraints as the key explanatory factor is only one of the perspectives invoked to explained housing market volatility. And it isn’t, in itself, a ‘bubble’ based explanation. That would require a different perspective on the psychology of market participants.

The other is that the way this debate is developing tells us something interesting about the discipline of economics. Housing economists got interested in the link from the housing market to the macroeconomy and back again back at the end of the 1980s. And the literature has evolved ever since. But this is an applied and policy-oriented field so it is held in relatively low regard by economists at the core of the discipline. As a consequence the housing literature made next to no impact on core debates in macroeconomics. That well-entrenched disciplinary hierarchy meant than for a long time some important insights were ignored. Belatedly, macroeconomists are recognizing that this is a gap that needs filling.

But that also takes us back to the starting point. To understand volatility in the housing market we need to understand how changing credit conditions interact with demographic change and inelastic supply. We have to model the very thing that mainstream macro abstracted from.

If you take an interest in these issues but are not an insider to the academic macroeconomics community you are left marvelling at some of the modelling decisions that have been taken along the way.

If you are ever called upon to explain to an unbeliever the sort of assumptions a DSGE model makes in order to get started – that is, strip away the maths and explain what it assumes the world is like – the response is quite likely to be incredulity. How can the self-evident complexity and heterogeneity of the economy and the fundamental importance of finance in shaping the fate of real world economies be omitted in order to preserve mathematical tractability? Isn’t that getting priorities the wrong way round? All modelling requires abstraction, of course. But it should be abstraction from the peripheral, not the core, characteristics of the system being modelled.

Of course, one response is that remedial work is being done to insert the missing pieces into the DSGE world. But that still leaves plenty of problematic characteristics intacted. And part of the critique is ontological. No amount of remedial work will correct the flaws.

Carlin begins the analysis from a different starting point. The attempt is to build models which involve different types of abstraction and which refuse to abstract from core characteristics of the economy. This is very welcome. We can but hope that it is an approach which gains traction.