After the global financial crisis of 2007 and 2008, economists around the world were left with egg on their faces. The Economist wrote that 2008 was a nightmarish year for economists and alluded to accusations of the discipline being the “dismal science.” Even Queen Elizabeth II asked during a London School of Economics briefing: “Why did nobody notice it?”
Despite attempts to pass the blame onto others, or proffer inscrutable theories to explain where it all went wrong, academics have to admit that current economic theories are no longer capable of explaining what is really going on with the economy.
Economics is a social science that adopts basic induction and deduction to simplify complex social phenomena. In this simplification process, rarely seen phenomena are excluded, while common phenomena are collated to devise principles which are then put to the test and thus produce theories.
Implicit in economic theory is the supposition that people are Homo economicus, that humans are rational beings seeking maximum interest and benefit. The trouble is, very few people actually act like this in the real world.
In the late 20th century, econometrics became popular and many mathematical models of economies were created to analyze, explain and predict various phenomena. Because the vast majority of data these models used was historical, they were made obsolete by the global financial crisis.
The Bank for International Settlements promoted Basel II, the second of the Basel accords, and demanded that banks adopt risk management models. However, as this was also mostly reliant on historical data, banks were subsequently obliged to adopt Basel III. Now, ideas like fuzzy logic from physics and extreme value theory from the field of statistics are being applied, while financial supervision bodies have started to apply stress tests when auditing financial institutions.
The Economist has pointed out how five major financial crises affected economic theory. For example, with the Great Depression, John Maynard Keynes said there was an overall lack of demand and classical economic equilibrium theory was inadequate. This is how Keynesian economics — with its emphasis on state spending to stimulate economic demand — began. From then on, economics placed less emphasis on supply and demand.
By the 1990s, when emerging economies started emulating advanced nations’ technology and investing heavily in traditional industries, the supply of automobiles, boats and steel and iron increased greatly. In addition, the bumper harvests of the 1990s, together with stable prices and long-term low interest rates set by central banks to stimulate the economy, are now believed to be causes of the bubble that caused the global financial crisis.
Furthermore, the recent over-investment in China and over-production there has disrupted markets around the globe.
Now, almost overnight, a raft of theories are being expounded, like psychological economics, geographical economics, new economic history, chaos theory, the economics of uncertainty, information economics, behavioral economics and experimental economics.
In 2009, when renowned business magnate and investor George Soros donated funds to establish the Institute for New Economic Thinking, he said: “The world has changed a lot. Economics has changed a lot, too. But the curriculum hasn’t.”
After the global financial crisis of 2007 and 2008, economic theory is facing yet another revolution and before long, the field of economics is sure to take on a whole new look.
Norman Yin is a professor of financial studies at National Chengchi University.
Translated by Drew Cameron
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