Discussing Global Economic Crash at AEA and Davos

Economists aren't typically an emotional bunch. The dismal science attracts more sober-suited math geeks than poetic seekers. But in Atlanta earlier this month, the annual meeting of the American Economic Association was home to more soul-searching than number crunching. Hundreds of the profession's most eminent thinkers turned out to hear panel after panel discuss how, exactly, they'd gotten things so wrong. Why did most of the world's top economists fail to forecast the financial crisis? Should the teaching of economics in universities be entirely rethought? While past stars at the AEA have been conservative, finance--oriented intellectuals like Eugene Fama, this year's meeting belonged to the liberal realists—Paul Krugman, Robert Shiller, and the man of the hour, Nobel laureate Joseph Stiglitz. Stiglitz delivered a keynote debunking the profession's key tenet—namely, that markets can be trusted. Leading into the crisis, Stiglitz said, "markets were not efficient and not self-correcting, and now huge costs in the trillions of dollars are being borne by every part of society."

The hand-wringing will continue this week at the World Economic Forum in Davos, Switzerland. Last year the buzz at Davos focused on how to pull the world back from the brink. But the key topic this time will be the crisis of conscience in economics itself. For the first time in decades, the profession is rethinking all the big questions. How do we create growth? How do we raise employment? How do we spread wealth? At least since Reagan, the consensus was that you just had to make the pie grow, and the best way to do that was to unshackle markets and investors, and then get out of the way. Wealth, and thus health, happiness, and all other good things, would eventually trickle down to all.

Now that this view has been proved false, a whole slew of new theories are competing to take its place. All are based, to one extent or another, on the idea that people are irrational actors, and that markets aren't always efficient. And in many cases, the new theories blend economics with entirely different disciplines. The adaptive-markets hypothesis, for instance, proposes a new way of looking at the economy, and in particular the financial markets: through the prism of evolutionary biology. The idea is simple enough: adherents view the economy and financial markets as an ecosystem, with different "species" (hedge funds, investment banks) vying for "natural resources" (profits). These species adapt to one another, but also go through periods of sudden mutations (read: crises), which dramatically alter the makeup of the ecosystem. To advocates of this theory, cell biology could hold the key to a new, unifying theory of economics; policymakers like Larry Summers can craft better policy, they suggest, by considering all market players as parts of a living organism.

The theory, which first emerged in 2004 but has gained importance since the crisis, is now heralded in the international business press, and was recently employed by the Federal Reserve to explain the behavior of foreign-exchange markets. The idea of introducing Darwin to Adam Smith has captivated many of the professions' best minds. "Cell biologists are much more interesting to me than economists right now," says Yale professor Robert Shiller, one of the handful who predicted the crisis.

Another hybrid field that's gaining steam is neuroeconomics, which combines brain science and economics: researchers map subjects' brain patterns to confirm how economic decision making takes place. Their work provides a scientific grounding for the more familiar field of behavioral economics. This school of thought tries to account for the imperfect economic decision making of real people (like those of us who waste money by driving farther away to get "cheaper" gas). It's been around for 30-odd years, and has recently produced numerous bestsellers (Freakonomics, Predictably Irrational, Nudge, etc). But post-crisis, it's being taken much more seriously by academic economists themselves, even the more conservative ones, and under the Obama administration has started to have a measurable impact on policy.

The last time the world experienced this sort of reset was after the Great Depression. Prior to that, economists saw capitalism as a perfectly self--regulating system, an idea overturned by the crash. That's when British economist John Maynard Keynes articulated all the ways in which government could and should help bail out an economy. Keynesian economics eventually lost its mojo in the 1970s, when an oil shock and political unrest led to high inflation and unemployment, something the theory didn't account for. The changing of the ideological guard was complete when Ronald Reagan rode in to unshackle the rich, and inflation fighter Paul Volcker was replaced at the head of the Federal Reserve Bank by fizzy free-market enthusiast Alan Green-span. The laissez-faire "Chicago school" economics—embodied by University of Chicago professor Milton Friedman—would remain dominant for the next three decades.

The consensus didn't change even under the Democratic administration of Bill Clinton. "I think that a couple of key moments [came] when James Carville said he wanted to be reincarnated as the bond market, and [Treasury Secretary] Robert Rubin and his crowd began to overshadow the social-democratic faction led by [Labor Secretary] Robert Reich," says Robert Johnson, a former fund manager for George Soros who now heads up economic policy for the Roosevelt Institute in New York. Financial economists built complex models that assumed that all you needed to know about a stock was already built into its price. Bubbles came and went in currency, tech stocks, and emerging markets, but they were seen as temporary and relatively harmless. When they popped, it was the job of central bankers to loosen monetary policy and get the party going again. Since the core assumption was that man is rational and markets are efficient, concern about risk took a back seat to concerns over how to make the good times last. It was a simple and elegant way of looking at the world, but one in which, as Nobel laureate Paul Krugman has pointed out, beauty trumped truth.

The new economics is already having real-world impacts. Stiglitz, who won his Nobel for saying way back in 1986 that markets really weren't that efficient (heresy at the time), is currently racking up frequent-flier miles advising governments around the world about how to restructure their financial systems. The country that has perhaps traveled the furthest in this respect is Britain. At the height of the bubble days, the City was arguably more freewheeling than Wall Street. Now Bank of England chief Mervyn King wants to split up banks "too big to fail" and talks about his concern over the "moral hazard" problem of bailouts. Chief regulator Adair Turner, who also says Britain's financial industry is too big, wants to clamp down on financial innovation. He's a big fan of Paul Woolley, a reformed financier now pouring millions into a research institute he founded at the London School of Economics. (Tellingly, it's called the Centre for the Study of Capital Market Dysfunctionality.) In some ways, the City is seeing a return to the days of old-style British banking, in which concerns about risk helped balance the scramble for reward.

In the United States, Obama's new regulation czar, Cass Sunstein, is a behavioral economist. The administration has used behavioral ideas to structure policies such as the stimulus package, and they will likely inform any new banking regulation, which Obama has indicated should be based on real data rather than abstract models. Behavioral economics is also behind the new push for prohibitive taxes on cigarettes, trans-fat-rich foods, and dirty energy usage. "Behavioral economics just isn't radical for anyone under 40," says Richard Thaler, coauthor (with Sunstein) of Nudge. Given that many of the up-and-coming stars of the profession are now behavioralists, the theory's policy influence will only grow.

None of this means that the ideas of the Chicago School aren't still useful; even irrationality can and should be mathematically modeled and studied. But they won't carry the complete dominance they once did. No one knows which school of thought will come out on top next—it's worth remembering that although the New Deal started in 1933, Keynes didn't write his General Theory until 1936. And those looking for the next grand, unifying theory of economics should perhaps consider the possibility that the greatest lesson of this downturn is that we shouldn't rely on just one tidy idea to encompass a world of human complexity. "We know that efficient-markets theory isn't completely right, but neither is anything else," says Thaler. The only real consensus view expressed at the AEA meeting was that economics is in for a difficult, yet potentially very fruitful period of questioning and cross-pollination. What finally emerges is likely to be more accurate than what came before—and less rational.