By 1970 or so, however, the study of financial markets seemed to have been taken over by Voltaire's Dr. Pangloss, who insisted that we live in the best of all possible worlds. Discussion of investor irrationality, of bubbles, of destructive speculation had virtually disappeared from academic discourse. The field was dominated by the "efficient-market hypothesis," promulgated by Eugene Fama of the University of Chicago, which claims that financial markets price assets precisely at their intrinsic worth given all publicly available information. (The price of a company’s stock, for example, always accurately reflects the company's value given the information available on the company’s earnings, its business prospects and so on.) And by the 1980s, finance economists, notably Michael Jensen of the Harvard Business School, were arguing that because financial markets always get prices right, the best thing corporate chieftains can do, not just for themselves but for the sake of the economy, is to maximize their stock prices. In other words, finance economists believed that we should put the capital development of the nation in the hands of what Keynes had called a "casino."

But there was something else going on: a general belief that bubbles just don't happen. What's striking, when you reread Greenspan's assurances, is that they weren't based on evidence -- they were based on the a priori assertion that there simply can't be a bubble in housing. And the finance theorists were even more adamant on this point. In a 2007 interview, Eugene Fama, the father of the efficient-market hypothesis, declared that "the word 'bubble' drives me nuts," and went on to explain why we can trust the housing market: "Housing markets are less liquid, but people are very careful when they buy houses. It's typically the biggest investment they're going to make, so they look around very carefully and they compare prices. The bidding process is very detailed."

So here's what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit -- and this will be very hard for the people who giggled and whispered over Keynes -- that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they'll have to do their best to incorporate the realities of finance into macroeconomics.

Many economists will find these changes deeply disturbing. It will be a long time, if ever, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. To some economists that will be a reason to cling to neoclassicism, despite its utter failure to make sense of the greatest economic crisis in three generations. This seems, however, like a good time to recall the words of H. L. Mencken: "There is always an easy solution to every human problem -- neat, plausible and wrong."

When it comes to the all-too-human problem of recessions and depressions, economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly. The vision that emerges as the profession rethinks its foundations may not be all that clear; it certainly won't be neat; but we can hope that it will have the virtue of being at least partly right.

Labels: economics