May the Best Theory Win
Foroohar, Rana, Newsweek
Byline: Rana Foroohar; With Barrett Sheridan in New York and Stefan Theil in Berlin
How economists are competing to make sense of our failed financial system.
Economists aren't typically an emotional bunch. The dismal science attracts more sober-suited math geeks than poetic seekers. But in Atlanta earlier this month, the annual meeting of the American Economic Association was home to more soul-searching than number crunching. Hundreds of the profession's most eminent thinkers turned out to hear panel after panel discuss how, exactly, they'd gotten things so wrong. Why did most of the world's top economists fail to forecast the financial crisis? Should the teaching of economics in universities be entirely rethought? While past stars at the AEA have been conservative, finance--oriented intellectuals like Eugene Fama, this year's meeting belonged to the liberal realists--Paul Krugman, Robert Shiller, and the man of the hour, Nobel laureate Joseph Stiglitz. Stiglitz delivered a keynote debunking the profession's key tenet--namely, that markets can be trusted. Leading into the crisis, Stiglitz said, "markets were not efficient and not self-correcting, and now huge costs in the trillions of dollars are being borne by every part of society."
The hand-wringing will continue this week at the World Economic Forum in Davos, Switzerland. Last year the buzz at Davos focused on how to pull the world back from the brink. But the key topic this time will be the crisis of conscience in economics itself. For the first time in decades, the profession is rethinking all the big questions. How do we create growth? How do we raise employment? How do we spread wealth? At least since Reagan, the consensus was that you just had to make the pie grow, and the best way to do that was to unshackle markets and investors, and then get out of the way. Wealth, and thus health, happiness, and all other good things, would eventually trickle down to all.
Now that this view has been proved false, a whole slew of new theories are competing to take its place. All are based, to one extent or another, on the idea that people are irrational actors, and that markets aren't always efficient. And in many cases, the new theories blend economics with entirely different disciplines. The adaptive-markets hypothesis, for instance, proposes a new way of looking at the economy, and in particular the financial markets: through the prism of evolutionary biology. The idea is simple enough: adherents view the economy and financial markets as an ecosystem, with different "species" (hedge funds, investment banks) vying for "natural resources" (profits). These species adapt to one another, but also go through periods of sudden mutations (read: crises), which dramatically alter the makeup of the ecosystem. To advocates of this theory, cell biology could hold the key to a new, unifying theory of economics; policymakers like Larry Summers can craft better policy, they suggest, by considering all market players as parts of a living organism.
The theory, which first emerged in 2004 but has gained importance since the crisis, is now heralded in the international business press, and was recently employed by the Federal Reserve to explain the behavior of foreign-exchange markets. The idea of introducing Darwin to Adam Smith has captivated many of the professions' best minds. "Cell biologists are much more interesting to me than economists right now," says Yale professor Robert Shiller, one of the handful who predicted the crisis.
Another hybrid field that's gaining steam is neuroeconomics, which combines brain science and economics: researchers map subjects' brain patterns to confirm how economic decision making takes place. Their work provides a scientific grounding for the more familiar field of behavioral economics. This school of thought tries to account for the imperfect economic decision making of real people (like those of us who waste money by driving farther away to get "cheaper" gas). …