To be sure, the purely rational theory remains useful for many things. It can be applied with care in areas where the consequences of violating Savage’s axiom are not too severe. Economists have also been right to apply his theory to a range of microeconomic issues, such as why monopolists set higher prices.
The theory, however, has been overextended. For example, the “Dynamic Stochastic General Equilibrium Model of the Euro Area,” developed by Frank Smets of the European Central Bank and Raf Wouters of the National Bank of Belgium, is very good at giving a precise list of external shocks that are presumed to drive the economy, but nowhere are bubbles modeled. The economy is assumed to do nothing more than respond in a completely rational way to these external shocks.
Milton Friedman and Anna Schwartz, in their 1963 book A Monetary History of the United States, showed that monetary-policy anomalies — a prime example of an external shock — were a significant factor in the Great Depression of the 1930s. Economists such as Barry Eichengreen, Jeffrey Sachs and Ben Bernanke have helped us to understand that these anomalies were the result of individual central banks’ efforts to stay on the gold standard, causing them to keep interest rates relatively high despite economic weakness.
To some, this revelation represented a culminating event for economic theory. The worst economic crisis of the 20th century was explained — and a way to correct it suggested — with a theory that does not rely on bubbles.
Yet events like the Great Depression, as well as the recent crisis, will never be fully understood without understanding bubbles. The fact that monetary policy mistakes were an important cause of the Great Depression does not mean that we completely understand that crisis, or that other crises fit that mold.
In fact, the failure of economists’ models to forecast the current crisis will mark the beginning of their overhaul. This will happen as economists’ redirect their research efforts by listening to scientists with different expertise. Only then will monetary authorities gain a better understanding of when and how bubbles can derail an economy and what can be done to prevent that outcome.
Robert Shiller is professor of economics at Yale University and chief economist at MacroMarkets.COPYRIGHT: PROJECT SYNDICATE
RSS