In an exasperated outburst, just before he left the presidency of the European Central Bank, Jean-Claude Trichet complained that “as a policymaker during the crisis, I found the available [economic and financial] models of limited help. In fact, I would go further — in the face of the crisis, we felt abandoned by conventional tools.”
Trichet went on to appeal for inspiration from other disciplines — physics, engineering, psychology and biology — to help explain the phenomena he had experienced.
It was a remarkable cry for help and a serious indictment of the economics profession, not to mention all those extravagantly rewarded finance professors in business schools from Harvard to Hyderabad.
So far, relatively little help has been forthcoming from the engineers and physicists in whom Trichet placed his faith, though there has been some response. Robert May, an eminent climate-change expert, has argued that techniques from his discipline may help explain financial-market developments. Epidemiologists have suggested that the study of how infectious diseases are propagated may illuminate the unusual patterns of financial contagion that we have seen in the last five years.
These are fertile fields for future study, but what of the core disciplines of economics and finance themselves? Can nothing be done to make them more useful in explaining the world as it is, rather than as it is assumed to be in their stylized models?
George Soros has put generous funding behind the Institute for New Economic Thinking. The Bank of England has also tried to stimulate fresh ideas. The proceedings of a conference that it organized earlier this year have now been edited under the provocative title What’s the Use of Economics?
Some of the recommendations that emerged from that conference are straightforward and concrete. For example, there should be more teaching of economic history. We all have good reason to be grateful that US Federal Reserve Chairman Ben Bernanke is an expert on the Great Depression and the authorities’ flawed policy responses then, rather than in the finer points of dynamic stochastic general equilibrium theory. As a result, he was ready to adopt unconventional measures when the crisis erupted and was persuasive in influencing his colleagues.
Many conference participants agreed that the study of economics should be set in a broader political context, with greater emphasis on the role of institutions. Students should also be taught some humility. The models to which they are still exposed have some explanatory value, but within constrained parameters and painful experience tells us that economic agents may not behave as the models suppose they will.
However, it is not clear that a majority of the profession yet accepts even these modest proposals. The so-called “Chicago School” has mounted a robust defense of its rational expectations-based approach, rejecting the notion that a rethink is required. The Nobel laureate economist Robert Lucas has argued that the crisis was not predicted because economic theory predicts that such events cannot be predicted. So all is well.
There is also disturbing evidence that news of the crisis has not yet reached some economics departments. Stephen King, chief economist at HSBC, notes that when he asks recent university graduates (and HSBC recruits a large number of them) how much time they spent in lectures and seminars on the financial crisis, “most admitted that the subject had not even been raised.”