In an exasperated outburst, just before he left the presidency of the European Central Bank, Jean-Claude Trichet complained that, “as a policymaker during the crisis, I found the available [economic and financial] models of limited help. In fact, I would go further: in the face of the crisis, we felt abandoned by conventional tools.”
Many conference participants agreed that the study of economics should be set in a broader political context, with greater emphasis on the role of institutions. Students should also be taught some humility. The models to which they are still exposed have some explanatory value, but within constrained parameters. And painful experience tells us that economic agents may not behave as the models suppose they will.
But it is not clear that a majority of the profession yet accepts even these modest proposals. The so-called “Chicago School” has mounted a robust defense of its rational expectations-based approach, rejecting the notion that a rethink is required. The Nobel laureate economist Robert Lucas has argued that the crisis was not predicted because economic theory predicts that such events cannot be predicted. So all is well.
Fortunately, others in the profession do aspire to relevance, and they have been chastened by the events of the last five years, when price movements that the models predicted should occur once in a million years were observed several times a week. They are working hard to understand why, and to develop new approaches to measuring and monitoring risk, which is the main current concern of many banks.
These efforts are arguably as important as the specific and detailed regulatory changes about which we hear much more. Our approach to regulation in the past was based on the assumption that financial markets could to a large extent be left to themselves, and that financial institutions and their boards were best placed to control risk and defend their firms.
These assumptions took a hard hit in the crisis, causing an abrupt shift to far more intrusive regulation. Finding a new and stable relationship between the financial authorities and private firms will depend crucially on a reworking of our intellectual models. So the Bank of England is right to issue a call to arms. Economists would be right to heed it.