Most economists were caught unawares by the world financial crisis because they were relying on the wrong models rather than the science of economics itself being at fault, a new study has suggested.
Leading economists analyse what went wrong during the crash in a special report for the journal Global Policy, published by the London School of Economics and Political Science (LSE) and Wiley-Blackwell.
While they reach different conclusions in four separate papers on the issue, there is broad agreement that economists based in central banks and other policy-making roles, failed to adopt the right macroeconomic models. In particular, they favoured a form of "business-school" economics which was too optimistic in its expectation of market performance and did not allow for instability in the financial sector.
Introducing the study, Rethinking Economics, Professor Tim Besley writes: 'Many practitioners now learn the economics that they put into practice in business schools rather than economics departments. Teaching the messier economics of failures in decision making, in markets, organizations and governments is easily kept out of the curriculum, inviting a Panglossian perspective.'
The study also includes a paper by Joseph Stiglitz in which he reinforces the argument that economic theory which could have predicted trouble ahead was overlooked in favour of a consensus model. He writes: 'A central tenet of the standard paradigm was that markets are efficient. Another is that markets are stable and self-correcting. Obviously, the crisis has "refuted" both these tenets. A major objective of the future research agenda should be to better understand market instability.'
Professor Stiglitz, of Columbia University, suggests four hypotheses which help explain what has happened to the world's economies but which are not included in conventional analysis. They are: that there have been large changes in the economy's risk properties, that changes in the financial sector have led to a deterioration in the quality of information and economic performance, that changes in the financial sector will slow the restoration of credit and that the present crisis may last longer than most downturns because it has meant structural transformation of the economy which can lead to under-utilization of resources.
Also contributing to the discussion on Rethinking Economics are David Hendry from the University of Oxford and Grayham Mizon from the University of Southampton. In a joint paper, they too argue that policy was based on flawed economic assumptions: 'Undue emphasis was placed on "punishing moral hazard", inflation targeting was mistakenly judged to be the primary concern, and the policy analysis was based on the wrong class of economic model.'
Peter Boettke and Christopher Coyne of George Mason University argue that government spending intended to maintain stability, avoid deflation and stimulate the economy leads to significant increases in the public debt, while Geoffrey Hodgson of the University of Hertfordshire suggest that faults in economic theory which were partly to blame for the financial crisis included the exaggeration of the possibilities for prediction in complex economic systems, the neglect of key concepts such as (unquantifiable) Keynesian uncertainty that help to explain the crash and the promotion of particular models that are remote from real-world phenomena.
Global Policy is a new innovative and interdisciplinary journal bringing together world class academics and leading practitioners to analyse both public and private solutions to globally relevant risks and problems demanding collective action.
The latest edition features not only the special analysis of macroeconomics but also includes articles on the regulation of international aviation, the possibility of reforms to the United Nations and G20, an examination of global poverty reduction after the Millennium Development Goals, and the future of food security.
The full edition of the journal is available online
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Posted 6 May 2011