20th century macroeconomics was born from the Great Depression.  The field started to take shape inspired by Keynes's alluring insights and contradictions.  Its relevance and legitimacy probably grew from the fact that the Great Depression was deep and persistent, which made it implausible, if not risible, to try to go back to the classical full-employment paradigm.  It is interesting to see how great economists like Irving Fisher and Bertil Ohlin moved away from a view that markets will take care of themselves to one in which the government plays a central role for smoothing the effects of the shock and facilitating recovery.  Hicks IS/LM apparatus helped to make this view accessible to the masses, and 20th century macroeconomics bore its mark despite the development of increasingly sophisticated models.

During the rest of the century after WWII, advanced economies coasted along without major macroeconomic shocks.  Thus, memories of the Great Depression started to fade away, which gave rise to the view that "the business cycle is dead."  Keynesian economists saw "automatic stabilizers" as the miracle pill, while New Classicals attributed the death of the cycle to the adoption of sensible monetary stabilization rules (e.g., Taylor rule).  These views, including the IS/LM apparatus, have two key features in common.  One of them is attributing macroeconomic malfunctioning essentially to one factor, namely, price/wage inflexibility.  In other words, depression and overheating are seen as resulting from product or labor market imperfections.  The other feature in common that, with the benefit of hindsight, now looks hard to fathom, is mostly ignoring financial market imperfections.  In many popular models capital markets are assumed to operate like clockwork.  Until recently, it was even difficult to publish any paper in which capital market imperfections were a central feature.  Voices like that of Hyman Minsky were silenced by a cacophonous wave of disapproval. 

However, the instant the subprime crisis flared up, a flood of papers started circulating in which financial imperfections of one form or another take center stage.  One was tempted to paraphrase the Duke of Mantua in Rigoletto and sing "il economista è mobile qual piuma al vento"!  Severe and quasi-religious institutions like the IMF dropped their guard admitting that financial imperfections can destabilize even the most virtuous economy.  They are now giving their blessing on formerly demonized policies like controls on capital inflows!  Granted, the shift is disorderly and as yet more confusing than illuminating, but it contains a new factor that I would claim characterizes the new macro, namely, that the financial sector could be the source of major macroeconomic shocks.  This is in my mind the defining characteristic of what I like to call 21st century macroeconomics.  I don't mean to say that the previous literature ignored deleterious effects associated with financial factors.  An important example in that respect is the so-called financial accelerator, associated with the names of Bernanke, Gertler and others.  But 20th century macroeconomics envisioned those factors as mere amplifiers of non-financial shocks, not as the main cause of macroeconomic turmoil. I don't mean to imply, either, that imperfections in product and labor markets are irrelevant.  They are still very relevant as anyone following the European economy could easily testify.  However, in the context of financial crisis – and from the perspective of 21st century macroeconomics – they are seen more as amplifiers than fundamental triggering factors.

As a little detour, I would like to remind the reader that 21st century macroeconomics started in Emerging Market economies, EMs, at least in the 1990s.  Michel Camdessus, when he was head of the IMF, called the Mexico Tequila crisis the first 21st century crisis.  And since then many of us have been involved in developing and testing theories in which imperfections in financial markets play a central role – and coining new terms like Sudden Stop and Phoenix Miracles.  The dominant view, however, was that financial crises in EMs reflected weak institutions in that part of the world, and could not possibly take place in advanced economies.  Unfortunately, the subprime crisis revealed, to the dismay of many in advanced economies, especially in Europe, that the world is more uniform than we thought!

Will 21st century macroeconomics go back to 20th century macroeconomics?  This cannot be discounted.  The Great Depression started on the October 1929 Wall Street crash, and one of its big money losers, Yale's professor Irving Fisher, wrote an after-the-fact outstanding piece on Debt Deflation in Econometrica 1933, highlighting the importance of financial factors in generating a Great Deflation as opposed to a run-of-the-mill recession.  Despite this, however, macroeconomic theory, as argued above, moved away from financial imperfection.  If this is coupled with how flaky the profession appears to be, a relapse to 20th century macroeconomics cannot be ruled out.  Therefore, it is imperative that macroeconomic theory incorporates imperfection in a deep way, and not just cloaked in the guise of mechanical financial friction shocks, which are becoming increasingly popular in the new crop of DSGE models.  Otherwise, I would not be surprised if the macro literature converges once again to a discussion of the statistical characteristics of unspecified supply shocks.

One way to prevent being sucked in by history, and fall prey to the law of intellectual inertia, is to focus on puzzles that 20th century macroeconomics would find it hard to rationalize, even after adding artificial financial friction patches.  Let me offer one puzzle to keep our thinking running in the right direction: 

• As recent empirical research has amply demonstrated, financial crisis follows credit boom; this is somewhat of a puzzle, but the most challenging puzzle in my opinion is that credit flows (both gross and net) increase in the run up of crisis, only to crash precipitously after the crisis' onset.  And this is not an isolated episode.  It is the general rule.  

Could a herding instinct be so powerful and predictable?  If so, this implies that standard microeconomic theory has feet of clay.  This may not be so serious a drawback for microeconomics, but it sweeps the rug under macroeconomics: the body is too heavy to be supported by feet of clay!  In other words, if herding is the key word, forget about microfoundations of macroeconomics.  I must confess that I am not ready to take such a radical stance.  My view is that perhaps this very puzzling phenomenon is linked to liquidity and, more to the point, endogenous liquidity, a phenomenon that has been largely ignored in 20th century macroeconomics (for a discussion of these issues, see my paper "The Price Theory of Money, Prospero's Liquidity Trap, and Sudden Stop: Back to Basics and Back").  Credit booms are, in a way, the polar opposite to bank runs: people rush to the bank to buy (not sell) its liabilities.  And, as they do so, the bank's liabilities become more liquid, driving other investors to join the buying frenzy.  You need a shock to reverse the trend, but since the trend stems from rising liquidity, it can be stopped by an apparently harmless shock like a rise in short-term US interest rates.  This will not necessarily have a big impact on long term investment projects, but if the anti-bank run is prompted by liquidity factors, the rise in US short-terms rates could freeze up the trend on the spur of a moment.  The latter feeds into the credit channel because the fall in formerly liquid assets lowers credit collaterals and dries up credit flows (Sudden Stop), generating the familiar output and employment contraction that accompany financial crisis.  Thus, in a nutshell, liquidity can provide a rationale for a sudden change in market mood without having to appeal to some form of irrationality.  Or, in other words, paraphrasing a popular expression: "it is liquidity, stupid!"

There are more puzzles that will help to keep our attention on the anatomy of financial crises, but I will stop here.  The 21st macroeconomic road is open to fresh and important ideas.  I only hope that the profession refrains from the temptation to drive exclusively looking at the rear-view mirror, and realizes that the financial sector contains a large trove of exciting new findings.