The blame game continues over who is responsible for the worst recession since the Great Depression – the financiers who did such a bad job of managing risk or the regulators who failed to stop them. But the economics profession bears more than a little culpability. It provided the models that gave comfort to regulators that markets could be self-regulated; that they were efficient and self-correcting. The efficient markets hypothesis – the notion that market prices fully revealed all the relevant information – ruled the day. Today, not only is our economy in a shambles but so too is the economic paradigm that predominated in the years before the crisis – or at least it should be.There follows the typical litany of complaints against modern macroeconomics: equilibrium assumptions, representative agent models, no room for finance. Some of these points make some sense, but there is no alternative approach that shows the way to go. Stiglitz talks about success in economic theory that has not gotten into macroeconomics.
Fortunately, while much of the mainstream focused on these flawed models, numerous researchers were engaged in developing alternative approaches. Economic theory had already shown that many of the central conclusions of the standard model were not robust – that is, small changes in assumptions led to large changes in conclusions. Even small information asymmetries, or imperfections in risk markets, meant that markets were not efficient.The problem is not to recognize that a model is just a model, but how to incorporate frictions into usable models. This is really hard. The most likely reason it has not been done yet is that nobody has figured it out, not that economists are ostriches.
Stiglitz also takes the typical potshot at market efficiency. Economists assumed markets were efficient so nobody stopped people from taking too much risk. I just don't get this argument. If people thought markets were efficient they would not have believed that extra return could arise with extra risk. The problem is that too many in the financial world, including regulators, did not really believe in efficient markets. Otherwise, they would have known that risks were being seriously piled up.