Monday, September 20, 2010

Neoclassical models (plus economists) failed!

A good narrative about how neoclassicals and rational expectationists assumed general equilibrium in everything (and created an economic mess, emanating from the Wall Street):
[...] New thinkers say they are still having trouble breaking in. Among the new NSF grant awardees is J. Doyne Farmer, a physicist at the Santa Fe Institute who is trying to bring the idea of complexity back into economics by making use of advanced computing power to map human economic behavior the way weather or climate change is tracked. But Farmer says he got his $450,000 grant for a three-year study of systemic risks in markets only after a sympathetic NSF case officer overruled negative assessments by “neoclassical economists” who reject any model that doesn’t tend toward general equilibrium. “The established view just holds this stuff back,” Farmer says. “One of the dangerous cultural patterns that economics has fallen into is an excessive emphasis on theorem proof for its own sake rather than what gives you scientific results. That’s led to a disdain for computer simulation.” Johnson, who is director of the new Institute for New Economic Thinking funded by George Soros, says: “You do see some new thinking, but it doesn’t get traction in terms of policy. It’s a symptom of how far right society has gone.”
The great names in the profession have not necessarily helped. The top economists in the Obama administration—Summers; Christina Romer, the just-departed chair of the Council of Economic Advisers; and her replacement, Austan Goolsbee—are all part of the orthodoxy. Critics say Summers should know as well as anyone how the old thinking has been outstripped. As a Harvard professor, Summers wrote after the 1987 stock-market crash that it was impossible to believe any longer that prices moved in rational response to fundamentals. He even cautiously advocated a tax on financial transactions. Yet Summers, one of the world’s most astute economists, later abandoned these positions in favor of Greenspan’s view that markets will take care of themselves. And in the current era, Summers and the rest of the Obama team seem to have underestimated the depth and systemic nature of the economic crisis. Stimulus spending was timid (in deference to political antipathy to big government), mortgage workouts meager, and financial reform minimalist. The administration maintains it did as much as it could under the political constraints, but others disagree. “The financial-reform bill and other changes in the regulatory landscape are more incremental,” says MIT’s Lo. “It’s a reaction to the most immediate set of events as opposed to a more profound rethinking about the underlying causes of the crisis.”
A little history is in order here: it was largely because the field of economics came to be dominated by “neoclassical” thought—or the idea that markets are rational and can reach “equilibrium” on their own—that so-called financial innovation on Wall Street was allowed to run amok in recent decades. That led directly to the crisis of 2007–09. No matter how crazy or complex the products got, the theory was that, with little government oversight, the inherent stability of markets would keep things from getting too out of hand. It was in large part because of this way of thinking that government intervention of any kind in the markets, including regulation, came to be seen as a kind of heresy, especially after the Soviet Union collapsed and command economies and “statism” were thoroughly discredited.
The new financial-reform law has changed that to some degree, but it still leaves most of the major decisions about government oversight to the same regulators who failed last time. We are still, to a large extent, flying blind in conceptual terms. Just as the Great Depression demonstrated to John Maynard Keynes and his followers that markets often behaved badly—leading to the Keynesian reinvention of economics in the ’30s—this present crisis drove home the truth, or should have anyway, that rational models of markets don’t work well because there are too many unknowns. People most often don’t behave as rational actors. There is no real equilibrium in the real world. Above all, market economies are capable of destroying themselves. This is especially true in the world of finance, which has always worked according to different rules than other sectors of the economy and is much more prone to panics and manias. In 1983, a young Stanford economist named Ben Bernanke published the first of a series of papers on the causes of the Great Depression. The financial system, Bernanke said, was not unlike the nation’s electrical grid. One malfunctioning transformer can bring down the whole system. “I’ve never had a laissez-faire view of the financial markets,” Bernanke told me, “because they’re prone to failure.” Even Friedrich Hayek, the godfather of 20th-century laissez-faire thinking, believed that financial markets were more subject “to bouts of instability,” says one of his biographers, Bruce Caldwell of Duke University, a self-described libertarian scholar.
Yet amid the free-market triumphalism of the post–Cold War era, all this hard-won wisdom about the differences in finance was forgotten or ignored. To policymakers in Washington, it seemed silly and nitpicky to treat finance as a different animal. The dominant thinkers were the “rational expectations” economists of the Chicago school who simply assumed capital flows, no matter how open, would be stable.