The standard macroeconomic models have failed, by all the most important tests of scientific theory.
They did not predict that the financial crisis would happen; and when it did, they understated
its effects. Monetary authorities allowed bubbles to grow and focused on keeping inflation low,
partly because the standard models suggested that low inflation was necessary and almost sufficient
for efficiency and growth. After the crisis broke, policymakers relying on the models floundered.
Notwithstanding the diversity of macroeconomics, the sum of these failures points to the need for
a fundamental re-examination of the models—and a reassertion of the lessons of modern general
equilibrium theory that were seemingly forgotten in the years leading up to the crisis. This paper
first describes the failures of the standard models in broad terms, and then develops the economics
of deep downturns, and shows that such downturns are endogenous. Further, the paper argues that
there have been systemic changes to the structure of the economy that made the economy more
vulnerable to crisis, contrary to what the standard models argued. Finally, the paper contrasts the
policy implications of our framework with those of the standard models.