Wed, Aug 29, 2012 - Page 9 News List

Financial theorists in denial about the global economic crisis

By Howard Davies

Indeed, King said: “Young economists arrive in the financial world with little or no knowledge of how the financial system operates.”

I am sure they learn fast at HSBC (in the future, one assumes, they will learn quickly about money laundering regulations as well), but it is depressing to hear that many university departments are still in denial.

That is not because students lack interest — I teach a course at Sciences Po in Paris on the consequences of the crisis for financial markets and the demand is overwhelming.

We should not focus attention exclusively on economists, though. Arguably the elements of the conventional intellectual toolkit found most wanting are the capital-asset pricing model and its close cousin, the efficient-market hypothesis. Yet their protagonists see no problems to address.

On the contrary, the University of Chicago’s Eugene Fama has described the notion that finance theory was at fault as “a fantasy” and argues that “financial markets and financial institutions were casualties rather than causes of the recession.”

The efficient-market hypothesis that he championed cannot be blamed, because “most investing is done by active managers who don’t believe that markets are efficient.”

This amounts to what we might call an “irrelevance” defense — finance theorists cannot be held responsible, since no one in the real world pays attention to them.

Fortunately, others in the profession do aspire to relevance and they have been chastened by the events of the past five years, when price movements that the models predicted should occur once in a million years were observed several times a week. They are working hard to understand why, and to develop new approaches to measuring and monitoring risk, which is the main current concern of many banks.

These efforts are arguably as important as the specific and detailed regulatory changes about which we hear much more. Our approach to regulation in the past was based on the assumption that financial markets could to a large extent be left to themselves, and that financial institutions and their boards were best placed to control risk and defend their firms.

These assumptions took a hard hit in the crisis, causing an abrupt shift to far more intrusive regulation. Finding a new and stable relationship between the financial authorities and private firms will depend crucially on a reworking of our intellectual models.

So the Bank of England is right to issue a call to arms. Economists would be right to heed it.

Howard Davies, former chairman of Britain’s Financial Services Authority, deputy governor of the Bank of England and director of the London School of Economics, is a professor at Sciences Po in Paris.

Copyright: Project Syndicate

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