It was the crash of 2008, which brought home the fact that there is something broken in economic theory. Two ideas – rational expectations theory and the efficient market hypothesis – have a monopoly of thought.
The “rational expectations hypothesis” became increasingly dominant in academic economics from the 1980s onwards, partly because it combined easy mathematics with an ideology attractive in the Thatcher-Reagan period. Its methodology of rational expectations could “prove” with apparently mathematical certainty that solvent banks would never face sudden liquidity crises, that forcing banks to hold excess capital was inefficient, that investors could perceive their collective best interests and that “markets are always right” in the sense that the financial prices incorporate the best possible forecasts about an uncertain future. The rational-expectations theorists gradually acquired a near-monopoly on senior university appointments and research funding—and in a process familiar to all economists, this intellectual monopoly has ended up not only crushing the competition but also decaying from within.
The economic orthodoxy was particularly dangerous in finance, since it allowed Nobel laureates to calculate that upheavals of the kind triggered by Lehman Brothers would not occur even once in a billion years. The impact on macroeconomic policy was equally pernicious. Rational expectations implied not only that market economies were self-stabilising but that attempts by government to manage demand with monetary and fiscal policy were doomed to failure, merely producing inflation.
The intellectual achievements of theoretical economics are meagre in comparison with classical physics and its political importance is too great to allow such slow progress.
INET is embracing multiple disciplines. The first round of grants have been given to people with backgrounds in law, history, medicine and science, as well as economics and finance. Several projects are taking concepts directly from science, such as the mathematics behind the spread of contagious diseases, and applying the principles to financial markets. During the financial crisis we saw instances of contagion – how a relatively small number of infected institutions made others sick
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