In an exasperated outburst, just before he left the presidency of the European Central Bank,Jean-Claude Trichet complained that, “as a policymaker during the crisis, Ifound the available [economic and financial] models of limited help. In fact, Iwould go further: in the face of the crisis, we felt abandonedby conventional tools.”
Trichet went on to appeal forinspiration from other disciplines – physics, engineering, psychology, andbiology – to help explain the phenomena he had experienced. It was a remarkablecry for help, and a serious indictment of the economics profession, not tomention all those extravagantly rewardedfinance professors in business schools from Harvard to Hyderabad.
So far, relatively little help has been forthcoming fromthe engineers and physicists in whom Trichet placed his faith, though there hasbeen some response. Robert May, an eminentclimate change expert, has argued that techniques from his discipline may helpexplain financial-market developments. Epidemiologistshave suggested that the study of how infectiousdiseases are propagated may illuminate the unusual patterns of financialcontagion that we have seen in the last five years.
These are fertile fields for future study, but what of thecore disciplines of economics and finance themselves? Can nothing be done tomake them more useful in explaining the world as it is, rather than as it isassumed to be in their stylized models?
George Soros has put generous funding behind the Institutefor New Economic Thinking (INET). The Bank of England has also tried tostimulate fresh ideas. The proceedings of a conference that it organizedearlier this year have now been edited under the provocativetitle What’s the Use of Economics?
Some of the recommendations that emerged from thatconference are straightforward and concrete. For example, there should be moreteaching of economic history. We all have good reason to be grateful that USFederal Reserve Chairman Ben Bernanke is an expert on the Great Depression andthe authorities’ flawed policy responses then, rather than in the finer pointsof dynamic stochastic general equilibriumtheory. As a result, he was ready to adopt unconventionalmeasures when the crisis erupted, and was persuasivein influencing his colleagues.
Many conference participants agreed that the study ofeconomics should be set in a broader political context, with greater emphasison the role of institutions. Students should also be taught some humility. The models to which they are stillexposed have some explanatory value, but within constrained parameters. Andpainful experience tells us that economic agents may not behave as the modelssuppose they will.
But it is not clear that a majority of the profession yetaccepts even these modest proposals. The so-called “Chicago School”has mounted a robustdefense of its rational expectations-based approach, rejecting the notion thata rethink is required. The Nobel laureateeconomist Robert Lucas has argued that the crisis was not predicted becauseeconomic theory predicts that such events cannot be predicted. So all is well.
And there is disturbing evidence that news of the crisishas not yet reached some economics departments. Stephen King, Group ChiefEconomist of HSBC, notes that when he asks recent university graduates (andHSBC recruits a large number of them) how much time they spent in lectures andseminars on the financial crisis, “most admitted that the subject had not evenbeen raised.” Indeed, according to King, “Young economists arrive in thefinancial world with little or no knowledge of how the financial systemoperates.”
I am sure they learn fast at HSBC. (In the future, oneassumes, they will learn quickly about money launderingregulations as well.) But it is depressing to hear that many universitydepartments are still in denial. That is notbecause students lack interest: I teach a course at Sciences Po in Paris on the consequencesof the crisis for financial markets, and the demand is overwhelming.
We should not focus attention exclusively on economists,however. Arguably the elements of the conventional intellectual toolkit found most wanting are the capital assetpricing model and its close cousin, the efficient-market hypothesis. Yet their protagonists see no problems to address.
On the contrary, the University of Chicago’sEugene Fama has described the notion that finance theory was at fault as “afantasy,” and argues that “financial markets and financial institutions were casualties rather than causes of the recession.”And the efficient-market hypothesis that he championed cannot be blamed,because “most investing is done by active managers who don’t believe thatmarkets are efficient.”
This amounts to what we might call an “irrelevance” defense: Finance theorists cannot beheld responsible, since no one in the real world pays attention to them!
Fortunately, others in the profession do aspire to relevance, and they have been chastened by the events of the last five years,when price movements that the models predicted should occur once in a millionyears were observed several times a week. They are working hard to understandwhy, and to develop new approaches to measuring and monitoring risk, which isthe main current concern of many banks.
These efforts are arguably as important as the specific anddetailed regulatory changes about which we hear much more. Our approach toregulation in the past was based on the assumption that financial markets couldto a large extent be left to themselves, and that financial institutions andtheir boards were best placed to control risk and defend their firms.
These assumptions took a hardhit in the crisis, causing an abruptshift to far more intrusive regulation.Finding a new and stable relationship between the financial authorities andprivate firms will depend crucially on a reworking of our intellectual models.So the Bank of England is right to issue a call toarms. Economists would be right to heedit.