http://hbr.org/2013/11/what-weve-learned-from-the-financial-crisis/ar/1
Five years ago the global financial system seemed on the verge of collapse. So did prevailing notions about how the economic and financial worlds are supposed to function.
The basic idea that had governed economic thinking for decades was that markets work. The right price will always find a buyer and a seller, and millions of buyers and sellers are far better than a few government officials at determining the right price. In the summer of 2007, though, the markets for some mortgage securities stopped functioning. Buyers and sellers simply couldn’t agree on price, and this impasse soon spread to other debt markets. Banks began to doubt one another’s solvency. Trust evaporated, and not until governments jumped in, late in 2008, to guarantee that major banks would not fail did the financial markets settle down and begin fitfully to function again.
That intervention seems to have prevented a second Great Depression—although the inhabitants of a few unfortunate countries such as Greece and Spain might beg to differ. But the economic downturn was definitely worse than any other since the Great Depression, and the world economy is still struggling to recover.
And what has been the impact on economic thinking? Seven years after the crash of 1929, John Maynard Keynes published the most influential work to come out of that era of turmoil—The General Theory of Employment, Interest and Money—yet not for at least another decade was it clear how influential that book would be. Five years after the crash of 2008 is still early to be trying to determine its intellectual consequences. Still, one can see signs of change. I’ve been following academic economics and finance as a journalist since the mid-1990s, and I’ve researched academic debates going back much further than that. To me, three shifts in thinking stand out: (1) Macroeconomists are realizing that it was a mistake to pay so little attention to finance. (2) Financial economists are beginning to wrestle with some of the broader consequences of what they’ve learned over the years about market misbehavior. (3) Economists’ extremely influential grip on a key component of the economic world—the corporation—may be loosening.
These trends are within and on the fringes of elite academia; I won’t attempt to delve into politics or public opinion in this article. That’s partly because doing so would make it impossibly broad, but also because—for the past half century at least—economic ideas born at the University of Chicago, MIT, Harvard, and the like really have tended to trickle down and change the world.
Macroeconomics Discovers Finance
A wildly oversimplified history of macroeconomics might go like this: Before the 1930s the discipline didn’t really exist. The focus was simple economics—the study of how rational, self-interested people interact to set prices and drive economic activity. This offered useful insights for the long run, but it wasn’t much help in a crisis. “Economists set themselves too easy, too useless a task,” Keynes complained of his peers in 1923, “if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.” The economics that he and others set about constructing for tempestuous times was dubbed macroeconomics.
One important aspect was monetary policy. The U.S. economist Irving Fisher argued that price instability (inflation and deflation) was the cause of most economic turbulence and could be averted by astute central bankers. Keynes agreed with this but thought it was not enough. One of his main observations was that although an individual is perfectly rational in wanting to hunker down and hoard his money during tough times, everyone’s hunkering down at the same time only makes things worse. Government needs to step in and avert such downward spirals by temporarily spending much more than it takes in.
Before long, younger “Keynesians” were building models that depicted the economy as a sort of hydraulic system: Pump money in here, generate jobs there. For policy makers, this had the virtue of being straightforward advice. But problems arose. Milton Friedman, of the University of Chicago—an adherent of Irving Fisher’s monetarist views—argued that the economic fine-tuning envisioned by the Keynesians was impossible to get right in practice. His opinion gained ground in policy circles during the inflationary 1970s, after Keynesian methods seemed to stop working. Within academia, though, it was Friedman’s former student Robert Lucas and the “rational expectations” critique that had the biggest impact. Lucas and his intellectual allies argued that if one assumed that people were rational, forward-looking actors who adjusted their behavior when economic circumstances changed (and economists generally did assume that), then the Keynesian models simply couldn’t be right. People were too smart and markets too dynamic for stimulus spending or other government interventions to have the desired effect.
