PARIS – 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.”
Trichet went on to appeal for inspiration from other disciplines – physics, engineering, psychology, and biology – to help explain the phenomena he had experienced. It was a remarkable cry for help, and a serious indictment of the economics profession, not to mention all those extravagantly rewarded finance professors in business schools from Harvard to Hyderabad.
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And there is disturbing evidence that news of the crisis has not yet reached some economics departments. Stephen King, Group Chief Economist of HSBC, notes that when he asks recent university graduates (and HSBC recruits a large number of them) how much time they spent in lectures and seminars on the financial crisis, “most admitted that the subject had not even been raised.” Indeed, according to King, “Young economists arrive in the financial world with little or no knowledge of how the financial system operates.”
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We should not focus attention exclusively on economists, however. Arguably the elements of the conventional intellectual toolkit found most wanting are the capital asset pricing model and its close cousin, the efficient-market hypothesis. Yet their protagonists see no problems to address.
On the contrary, the University of Chicago’s Eugene Fama has described the notion that finance theory was at fault as “a fantasy,” and argues that “financial markets and financial institutions were casualties rather than causes of the recession.” And the efficient-market hypothesis that he championed cannot be blamed, because “most investing is done by active managers who don’t believe that markets are efficient.”
This amounts to what we might call an “irrelevance” defense: Finance theorists cannot be held responsible, since no one in the real world pays attention to them!
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.
