Global Financial Crisis Fails to Change Economic Thinking

by: Research Recap

Even though the financial crisis represented a profound challenge to accepted economic thinking, there is little evidence that it has prompted any fundamental changes in the accepted paradigm. Therefore, policy-making will remain predictable even if its effectiveness is limited, Oxford Analytica argues in this complimentary download from the Alacra Store.

Selected excerpts:

Economists share basic assumptions about rationality and self-interest. They condition these with ideas about information flow and psychological apprehension, the long-run neutrality of money and the short-run problem of price stickiness. They teach common models to describe economic activity at the micro- and macro- levels. Economists also have a fairly stable array of problems considered worthy of consideration, as well as a well-established toolkit for addressing them.

However, the crisis of 2008-09 represented a profound challenge to accepted economic thinking:

  • The implosion of the securitised sub-prime mortgage market and subsequent turmoil in inter-bank lending markets challenged economists’ collective self-confidence.
  • Not only did most economists fail to recognise the emergence of the bubble, they also failed to anticipate that the financial sector would underestimate both risk and exposure.

Since the failure of Lehman Brothers in September 2008, policymakers in a number of governments and central banks have engaged in experimentation, including engaging in quantitative easing and intervening in sovereign debts markets.

Despite this experimentation, it is premature to conclude that there is some fundamental change in economic thinking at work.

Economists who absorbed this vast and complex body of knowledge are unlikely to acknowledge that it has all been a mistake. On the contrary, they will strive to incorporate the new facts of the crisis into the pre-existing framework.

Although the crisis has exposed serious weaknesses in the neoclassical synthesis, no alternative paradigm is likely to eclipse it in the short term. Moreover, there are strong intellectual and social pressures that work to hold the paradigm in place. In practice, this means that policymakers will continue to experiment with ad hoc solutions, although they will attempt to justify these with reference to the existing body of core assumptions. Policy-making will remain predictable even if its effectiveness is limited.