George Washington’s Blog 
Monday, March 2, 2009
As I have previously pointed out, most economists understand neither the cause of, nor the solution to, the economic crisis .
A new paper  by an international group of economics professors now says the same thing.
The paper shows that the what the economics profession has adopted as gospel – that the economy is inherently stable – is utterly false.
The paper also says that mainstream economics has missed the fact that speculative bubbles lead to inevitable crashes, and that such popped-bubble-crashes can bring down the whole economy.
And the paper lambasts the risk models used to justify the casual buying and selling many trillions of dollars worth of credit default swaps and CDOs.
Why Did They Get It So Wrong?
Why did they get it so wrong? Why did mainstream economists stick to such faulty models and ignore basic truths about how the economy really works?
Certainly part of it is arrogance and ignorance.
But perhaps it is also because the wealthy make a lot of money in boom times, and in busts – as they understand that busts follow booms and invest appropriately ahead of time. By following the commonly-accepted dogma, the public is none-the-wise, and the elites can make a killing on both the boom and bust.
Mainstream economists have lapped up the theories of Keynes and Friedman as if they were proven beyond a shadow of a doubt. But Keynes and Friedman both conveniently ignored the fact that if the bubble is big enough, the resulting crash will take out the economy (like it is currently doing). Indeed, both Keynes and Friedman were faithful servants of those in power  (that may, in fact, be one of the main reasons they were promoted to such an exulted status as the two leading economists of the twentieth century).
And both provided the illusion that problems can easily be fixed, without addressing the real, core problems:
- Keynesian economics implies that you can keep on blowing endless speculative bubbles so long as the government is willing to “stimulate” the economy when things crash
- Likewise, Friedman teaches that if you just increase the money supply enough, you can let business go wild and leverage itself into all the speculative bubbles it wants. That’s why – even a couple of years ago – the economic big-wigs said that they had everything figured out, and everyone could go hog wild and the system would still remain stable
The powers-that-be do not like economists who say “Boys, if you don’t slow down, that bubble is going to get too big and pop right in your face”. They don’t want to hear that they can’t make endless money using crazy levels of leverage and 30-to-1 levels of fractional reserve banking, and credit derivatives. And of course, they don’t want to hear that the Federal Reserve is a big part of the problem.
So Keynes and Friedman were elevated to the status of prophets, and those economists asking hard questions – like those in the Austrian school of economics – were ignored and sidelined. Likewise, those pushing voodoo theories  justifying the tremendous increase in leverage and in the use of credit derivatives were lionized, while those questioning such nonsense were ridiculed.
Here are some excerpts to give the flavor of the paper:
The global financial crisis has revealed the need to rethink fundamentally how financial systems are regulated. It has also made clear a systemic failure of the economics profession. … It is obvious, even to the casual observer that these models fail to account for the actual evolution of the real-world economy. Moreover, the current academic agenda has largely crowded out research on the inherent causes of financial crises. There has also been little exploration of early indicators of system crisis and potential ways to prevent this malady from developing. In fact, if one browses through the academic macroeconomics and finance literature, “systemic crisis” appears like an otherworldly event that is absent from economic models. Most models, by design, offer no immediate handle on how to think about or deal with this recurring phenomenon. In our hour of greatest need, societies around the world are left to grope in the dark without a theory. …
The implicit view behind standard models is that markets and economies are inherently stable and that they only temporarily get off track. The majority of economists thus failed to warn policy makers about the threatening system crisis and ignored the work of those who did. …
The confinement of macroeconomics to models of stable states that are perturbed by limited external shocks and that neglect the intrinsic recurrent boom-and-bust dynamics of our economic system is remarkable. After all, worldwide financial and economic crises are hardly new and they have had a tremendous impact beyond the immediate economic consequences of mass unemployment and hyper inflation. This is even more surprising, given the long academic legacy of earlier economists’ study of crisis phenomena … This tradition, however, has been neglected and even suppressed. …
Many of the financial economists who developed the theoretical models upon which the modern financial structure is built were well aware of the strong and highly unrealistic restrictions imposed on their models to assure stability. Yet, financial economists gave little warning to the public about the fragility of their models . . .
Much of its research efforts are not directed towards the most prevalent needs of society. [There is now a] dominance of a paradigm that has no solid methodological basis and whose empirical performance is, to say the least, modest. … The economics profession bears some responsibility for the current crisis. It has failed in its duty to society to provide as much insight as possible into the workings of the economy and in providing warnings about the tools it created. It has also been reluctant to emphasize the limitations of its analysis. We believe that the failure to even envisage the current problems of the worldwide financial system and the inability of standard macro and finance models to provide any insight into ongoing events make a strong case for a major reorientation in these areas and a reconsideration of their basic premises.