The Fable of Price Swings as Bubbles
THE GLOBAL FINANCIAL CRISIS that began in 2007 has led many observers to question the relevance of contemporary macroeconomic and finance theory for understanding outcomes and guiding policy. Many economists have also recognized that their portrayals of individual behavior and markets are deficient. But they have remained steadfast in their belief that they should continue to search for better, and even more complete, fully predetermined accounts of outcomes.1
To be sure, swings in housing, equity, and other markets, which are often blamed for the crisis, substantially eroded faith in the ability of financial markets populated by rational participants to allocate society’s capital nearly perfectly. Nevertheless, Rational Expectations accounts of the intrinsic values of assets have continued to serve as the foundation for modeling swings in prices and risk. For example, in modeling asset-price swings, economists portray them as mechanical departures from REHbased, supposedly true values of prospects and companies.
1For example, Krugman (2009) overlooked the possibility that economists’ insistence on fully predetermined accounts of market outcomes should be reconsidered. Echoing a widely held belief, Krugman suggested that adding a mechanistic account of the financial sector to Rational Expectations macroeconomic models, as Bernanke et al. (1999) had done, would render such models relevant for understanding outcomes and guiding policy. For further remarks on this point, see footnote 17 in Chapter 1.