Tom Barry

An economics crisis as well as an economic crisis?

The financial crisis has damaged - perhaps irretrievably - many theories that most economists (including me) thought of as cornerstones of our discipline. Among these has been the idea that markets have an innate tendency to be self-equilibrating and rational.

This leaves us with something of a problem: if markets are prone to herding and momentum, what should be done to control their excesses? Yesterday, I heard Lord Turner of the UK's Financial Services Authority offer some ideas. He was speaking at an event in Washington organised by the National Journal and The Economic Club of America. (Full stream of the talk is available here.)

In a provocative talk, Turner discussed the extent to which the financial crisis was not just a crisis of specific institutions but a crisis of economic theory. Specifically, if we accept that deeper and more liquid markets are not always a good thing - because of the volatility they produce, for instance - then we must then answer not only the question of how big they should be, but also how government policy should go about controlling them.

The good news is that economics already has some good explanations for these effects, albeit ones that have been sidelined in recent years.

John Maynard Keynes was talking about investors' "animal spirits" over 70 years ago in his General Theory of Employment, Interest and Money. Although the term featured heavily in my first year undergraduate course in macroeconomics, by the time I reached graduate school, it had been subsumed by neat mathematical models based on representative rational agents.

The term has been resurrected in the last year and is the title of a recent book by Robert Shiller and George Akerlof. The new(ish) field of behavioural economics is also starting to provide the intellectual underpinnings of a new theory of how markets behave. My hope is that it will help governments design better policy too.

Posted at 15:24 30 October 2009 by Tom Barry  |  Comments[0]