The financial crisis and the systemic failure of academic economics

This opinion paper is the outcome of one week of intense discussions within the working group on “Modeling of Financial Markets” at the 98th Dahlem Workshop, 2008. David Colander served as moderator of this group and Thomas Lux served as Rapporteur. We are grateful to Carlo Jaeger and Rupert Klein for organizing this stimulating meeting and to Deirdre McCloskey and Peter Sørensen and other participants for helpful comments. The present version is the reprint of Kiel Working Paper, 1489, Institute for the World Economy, Kiel, 2009, that also appeared in electronic format in many other places. A revised version of this manuscript appeared in print as Colander, D., Haas, A., Goldberg, M., Juselius, K., Kirman, A., Lux, T., Sloth, B. (2009). “The Financial Crisis and the Systemic Failure of the Economics Profession.” Critical Review, 21 (2–3), 249–267. Introduction The global financial crisis has revealed the need to rethink fundamentally how financial systems are regulated. It has also made clear a systemicfailure of the economics profession. Over the past three decades, economists have largely developed and come to rely on models that disregard key factors – including heterogeneity of decision rules, revisions of forecasting strategies, and changes in the social context – that drive outcomes in asset and other markets. It is obvious, even to the casual observer that these models fail to account for the actual evolution of the real-world economy. Moreover, the current academic agenda has largely crowded out research on the inherent causes of financial crises. There has also been little exploration of early indicators of system crisis and potential ways to prevent this malady from developing. In fact, if one browses through the academic macroeconomics and finance literature, “systemic crisis” appears like an otherworldly event that is absent from economic models. Most models, by design, offer no immediate handle on how to think about or deal with this recurring phenomenon. In our hour of greatest need, societies around the world are left to grope in the dark without a theory. That, to us, is a systemic failure of the economics profession.