The Human Factor in Economic Theory

By Keay, Justin | Global Finance, June 2012 | Go to article overview
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The Human Factor in Economic Theory

Keay, Justin, Global Finance


Traditional economic theory has been challenged by recent market events in global financial markets, and that challenge has given rise to a new generation of economic soothsayers who are looking more deeply into the impact of finance on the real economy.

In mid-September 2007, desperate depositors started queuing up outside branches of Britain's Northern Rock, amid growing fears the institution might collapse. According to then-chancellor of the Exchequer Alistair Darling, he and Bank of England governor Mervyn King were abroad watching events unfold on TV. King - an academic economist by training - said to him: "You know, they are behaving quite rationally."

King's remark demonstrated with startling clarity the importance of individual economie behavior on the broader economy, and vice versa, and the failure of global economic policy to account for, and be accountable to, humanity. King has been widely criticized for his inaction in the early days of the financial crisis when he held off injecting money into threatened institutions for fear of encouraging moral hazard.

In reality, very few economists anticipated the current crisis even though in retrospect the warning signs - the overgearing, the asset bubbles, the lack of financial market transparency - were plain to see. But hindsight is often 20/20. "We have entered a dark age for macroeconomics... all the theory taught in management schools proved completely useless in predicting the crisis," says Jerry Caprio, an economist at Williams College in Massachusetts.

Since the Great Depression, the trend has been for an unambiguous orthodoxy - what John Kenneth Galbraith dubbed "the conventional wisdom" - to hold sway amid prevailing economic reality. In the years between 1945 and the 1970s, when the oil price explosion precipitated high inflation and a slump in demand, there was the Keynesian belief that governments could and should intervene. Over the 1980s and 1990s, supplysiders won the argument: The market was king, liberalization and privatization were the way forward.The more extreme version of this pro-market approach was dubbed "freshwater economics," which held that financial markets are efficient and the broader economy was stable and self-correcting.

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