As with preceding crashes, the causes of the credit crunch have been much analysed and debated. The obvious lightning rods for criticism were the bankers, who were earning fabulous salaries…for taking risks that turned out to be cataclysmic consequences…when the bets went wrong; the regulators who failed to keep up with the pace of innovation in financial products; the American homeowners who took out subprime loans they could never afford to pay; the central banks, who often seemed in denial about the extent of the problem; and the economists who designed the flawed mathematical models in the first place.
This still leaves the question of how so many people in the financial industry could have been misled about the risks they were running and unaware of the dangers. The reason, I believe, is that the fundamental assumptions that form the basis of economic theory are flawed. This means that not just the mathematical models, but [also] the actual mental models that economists have of the economy are completely wrong…The economy is unfair, unstable and unsustainable. But economic theory has no way of dealing with these issues…
Economic theory is supposed to be about optimising the allocations of recourses. In reality the rich really do get richer. In 2009 one hedge fund manage earned $2 billion, while over one billion people earned less than $1 a day. That’s a strange way to allocate recourses.
According to the theory, the ‘invisible hand’ should keep asset process at a stable level. Bit in reality, assets, including oil, gold and hard currencies are subject to enormous gyrations. In late 2007 the price of oil surged to over $140 a barrel then plunged to under 440, all in a space of a few months.
According to the theory, the economy can grow forever without encountering limits. The reality is that we are bumping up against the hard constraints due to things like over-crowding, climate change and environmental degradation. As the environmentalists point out, never-ending growth is the philosophy or a cancer cell.
So why to we persist with an economic theory that is so obviously unfit for purpose?