from real-world economics review, issue no. 49, 12 March 2009, pp. 1-7, http://www.paecon.net/PAEReview/issue49/Keen49.pdf
The most important thing that global financial crisis has done for economic theory is to show that neoclassical economics is not merely wrong, but dangerous.
Neoclassical economics contributed directly to this crisis by promoting a faith in the innate stability of a market economy, in a manner which in fact increased the tendency to instability of the financial system. With its false belief that all instability in the system can be traced to interventions in the market, rather than the market itself, it championed the deregulation of finance and a dramatic increase in income inequality. Its equilibrium vision of the functioning of finance markets led to the development of the very financial products that are now threatening the continued existence of capitalism itself.
Simultaneously it distracted economists from the obvious signs of an impending crisis—the asset market bubbles, and above all the rising private debt that was financing them. Paradoxically, as capitalism's “perfect storm” approached, neoclassical macroeconomists were absorbed in smug self-congratulation over their apparent success in taming inflation and the trade cycle, in what they termed “The Great Moderation”. Ben Bernanke's contribution to this is worth quoting at length:
… the low-inflation era of the past two decades has seen not only significant improvements in economic growth and productivity but also a marked reduction in economic volatility…, a phenomenon that has been dubbed “the Great Moderation”. Recessions have become less frequent and milder, and … volatility in output and employment has declined significantly… The sources of the Great Moderation remain somewhat controversial, but … there is evidence for the view that improved control of inflation has contributed in important measure to this welcome change in the economy … Bernanke, 2004 (http://www.federalreserve.gov/boarddocs/speeches/2004/20041008/default.htm)
It is all very well to have economic theory dominated by a school of thought with an innate faith in the stability of markets when those markets are forever gaining—whether by growth in the physical economy, or via rising prices in the asset markets. In those circumstances, academic economists aligned to PAECON can rail about the logical inconsistencies in mainstream economics all they want: they will be, and were, ignored by government, the business community, and most of the public, because their concerns don't appear to matter.
They can even be put down as critics of capitalism—worse still, as proponents of socialism—because it seems to those outside academia, and to neoclassical economists as well, that what they are attacking is not economic theory, but capitalism itself: “You think markets are unstable? Shame on you!”
The story is entirely different when asset markets crash beneath a mountain of debt, and the ensuing fallout threatens to take the physical economy with it. Now it should be possible to have the critics of neoclassical economics appreciated for what we really are: critics of a fundamentally false theory of the operations of a market economy, and tentative developers of a new, realistic analysis of the nature of capitalism, warts and all.
Given how severe this crisis has already proven to be, the reform of economic theory and education should be an easy and urgent task. But that is not how things will pan out. Though the “irresistible force” of the Global Financial Crisis is indeed immense, so to is the inertia of the “immovable object” of economic belief.
Despite the severity of the crisis in the real world, academic neoclassical economists will continue to teach from the same textbooks in 2009 and 2010 that they used in 2008 and earlier (laziness will be as influential a factor here as ideological commitment). Rebel economists will be emboldened to proclaim “I told you so” in their non-core subjects, but in the core micro, macro and finance units, it will be business as usual virtually everywhere. Many undergraduate economics students in the coming years will sit gobsmacked. as their lecturers recite textbook theory as if there is nothing extraordinarily different taking place in the real economy.
The same will happen in the academic journals. The editors of the American Economic Review and the Economic Journal are unlikely to convert to Post-Keynesian or Evolutionary Economics or Econophysics any time soon—let alone to be replaced by editors who are already practitioners of non-orthodox thought. The battle against neoclassical economic orthodoxy within universities will be long and hard, even though its failure will be apparent to those in the non-academic world.
Much of this will be because neoclassical economists are genuinely naïve about their role in causing this crisis. From their perspective, they will interpret the crisis as due to poor regulation, and to government intervention in areas that should have been left to the market. Aspects of the crisis that cannot be solely attributed to those causes will be covered by appealing to embellishments to basic neoclassical theory. Thus, for example, the Subprimes Scam will be portrayed as something easily explained by the theory of asymmetric information.
They will seriously believe that the crisis calls not for the abolition of neoclassical economics, but for its teachings to be more widely known. The very thought that this financial crisis should require any change in what they do, let alone necessitate the rejection of neoclassical theory completely, will strike them as incredible.
In this sense, they are like the Maxwellian physicists about whom Max Planck remarked that “A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it” (Kuhn 1970, p. 150).
But physics is charmed in comparison to economics, since it is inherently an empirical discipline, and quantum mechanics gave the only explanation to the empirically quantifiable black body problem. Planck's confidence that a new generation would take the place of the old was therefore well-founded. But in economics, not only will the neoclassical old guard resist change, they could, if economic circumstances stabilise, give rise to a new generation that accepts their interpretation of the crisis. The is how the success of the Keynesian counter-revolution came about, and it is why we have we entered this crisis with an even more rabid neoclassicism than confronted Keynes in the 1930s.