Smith versus Keynes: Economics and Political Economy in the Post-Crisis Era

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Alongside politicians, bankers, and CEOs, few groups have received as much opprobrium for the 2008 financial crisis as economists. "Economists are the forgotten guilty men" was the phrase employed in February 2009 by Anatole Kaletsky, editor-at-large for the London Times, when explaining why "a bank with just $1 billion of capital [would] borrow an extra $99 billion and then buy $100 billion of speculative investments." (1) Self-indulgence and imprudence had a part, but so too, Kaletsky asserted, did those economists who insisted that their models "proved" that occurrences such as Long Term Capital Management's demise in 1998 or Lehman Brothers's collapse almost exactly ten years later were mathematically likely to happen only once every billion years. (2) Kaletsky's wider claim was that mainstream economics had been so discredited by the financial crisis that economics itself required an "intellectual revolution" or risked being reduced to a somewhat suspect sub-branch of mathematical modeling and statistical analysis.

Kaletsky has not been alone in making such arguments. Economic historian Harold James made a similar point, albeit more temperately:

   [A]n overwhelming majority of modern economists were misled by
   treating short-term trends as if they were permanent phenomena that
   could be used to derive reliable behavioral correlations and
   extrapolations. There were some exceptions ... but such analysts
   were dismissed as alarmist or eccentric, not only by the
   commercially driven economists who worked for financial
   institutions as de facto salesmen, but also by the overwhelming
   majority of academic economists, who were also subject to
   commercial pressures in the forms of peer evaluation and patterns
   of career development. These economists instilled a false
   complacency in politicians and other policymakers. (3)

In March 2009, Willem Butler, a former external member of the Bank of England's Monetary Policy Committee, likewise referred to "[t]he unfortunate uselessness of most 'state of the art' academic monetary economics." (4) Though unwilling to demand either a complete paradigm change or a defenestration of the economics profession, the Economist suggested that the financial meltdown raised profound questions of coherence about two specific fields of economics: financial economics and macroeconomics. "Few financial economists," it suggested, "thought much about illiquidity or counterparty risk, for instance, because their standard models ignore it." Likewise, "[m]acroeconomists also had a blind spot: their standard models assumed that capital markets work perfectly." (5)

These claims evoked a strong riposte from the Nobel Prize economist Robert Lucas in defense of the Efficient Market Hypothesis (EMH), the claim that the price of a financial asset reflects all relevant, generally available information. "One thing," Lucas wrote, "we are not going to have, now or ever, is a set of models that forecasts sudden falls in the value of financial assets, like the declines that followed the failure of Lehman Brothers in September [2008]." (6) Since the late Paul Samuelson published his proof for one version of the EMH in 1965 and Eugene Fama detailed the theory and evidence for three forms of the EMH in 1970, (7) the EMH had been subject to consistent criticism. But none of these critiques, Lucas maintained, had proved its falsity. Other economists, however, argued that the stock market meltdown demonstrated the EMH's inability to account for the market overpricing assets such as mortgages. On this basis, they conjectured, "the EMH, as applied to the stock market in aggregate, must be discarded or modified." (8)

While these discussions are important, much of the debate about economic theory following the 2008 crisis has focused upon the place of models in economics. Some contemporary economists seem hesitant to question the appropriateness of their heavy dependence on models and mathematical logic. …


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