A few economists warned about the risk of a financial crisis, but the least one can say is that they were not taken seriously by most of the economics profession. Why is that? Why did so many, especially the best and the brightest in the profession, not see the warning signals that were there?
Economic theories affect the way we see and interpret economic data. If we believe that financial markets are efficient and capable of self-regulation, we are likely to interpret a bubble-like movement in real estate and equity prices as evidence of the marvels of free markets.
If we believe, as macroeconomists do, that consumers and producers are rational and fully informed agents, we do not worry that large debt build-ups will be harmful because this build-up must be the result of rational and fully informed decisions that will lead to a new equilibrium.
Thus an economic theory can work as a framing device conditioning us to interpret the facts in a way that is consistent with the theory. Psychologists call this a “confirmation bias”.
It should not be like that. After all, economics is a science (or should be one). And in science, theories should be formulated in such a way that they can be refuted. The main preoccupation of scientists should then be to try to refute these theories.
But that is not the way macroeconomics has evolved during the last two decades. Instead it has become a system of beliefs, some will say a religion, about rational and fully informed agents operating in efficient markets. This belief has become so strongly held that it has fallen victim to the confirmation bias. As a result, it has stopped being science.
The present crisis creates opportunities. The accumulation of facts that refute the mainstream macroeconomic models has become so strong that only the most fundamentalist believers will want to cling to these theories.
The crisis also creates the opportunity to develop better models. This will be the hard part because the world the macroeconomists will have to model is one crowded by agents who have trouble understanding the way the economy functions.
It is also a world in which the interaction between these imperfectly informed individuals regularly creates collective movements of euphoria and panics. These phenomena are hard to model. Yet this is what macroeconomists will have to do if they want to regain respectability as scientists.
Clearly the financial crisis is not only due to the delusions of macroeconomists. The delusions were quite widespread among bankers, supervisors, media and policymakers. Yet society expects the community of scientists to be less prone to delusions than the rest. In that sense the responsibility of the economics profession is crushing.