Good God, man, flee for sanctuary on the higher ground of the other social sciences & technologies.  Real progress will be made when money and its' use are electronic and integrated with empirical models which provide an alternative to current concepts and the institutions they support.  An information utility that optimizes social outcomes rather than gross production, consumption and profit may well disintermediate the actors central to both contemporary capitalism and its' instability.

I find it amazing that all the theory and practice underlying capitalism and brought to us by idealogues - dressed as scientists - NOT scientists can fail so often, with such velocity and flair yet many who write on this site and elsewhere continue to support capitalism in all it's glory and across-the-board. Yet, one researcher (a true scientist) is over zealous with his predictions about the Himalayan glaciers and the whole world is ready to pillory the empirically-based concept of climate change.

The quote below is from a recent article in The Economist "An anthropologist on the run" January 28th, 2010. It basically summarizes what capitalism has done for society and what will happen to the have-nots if the haves continue to ignore the data with respect to climate change.

Thus Thomas Jefferson’s mandate to pursue happiness “falls like kerosene on the torch of liberty”, warming many but “scorching and blinding” countless others.

"The most important new book about the origins of the economic crisis . . . "

Actually, the two most important books for understanding the curent crisis are both old: Charles Kindleberger's Manias, Panics and Crashes, arnd Hyman Minsky's Stabilizing an Unstable Economy.

It's not actually rocket science.

,

Macroeconomics’ problem might be “that the types of causes mentioned for the current crisis are difficult to systematize.” But there is one advantage that economists have over scientists.  An economic forecast is in itself a force influencing the outcome and unlike weather forecasts, it can generate a full-blown domino effect. 

Although economists could not, in their majority, predict how deep the crisis could become in the US, and how the rest of the world could be affected, a number economists had been (since January 2008) talking themselves into a self-fulfilling prophecy that was recession. 

It is possibly a self-fulfilling prophecy just like the one mentioned in your book “Irrational Exuberance”: enough people believe in an idea and it becomes mainstream thinking (or conventional wisdom as you put it).  It is based on similar hunches...reinforced by news media.

The hard part is recognizing the causes of a future downturn before the downturn. the downturn itself as well as increased unemployment, decreased wages and prices, increased savings, ... are all symptoms not causes. Human systems fail catastrophically when external forces push people/markets to move unnaturally in a single direction. When the visible hand presses on the scales the invisible hand restores balance.

There is an interesting point here, on which it would be great to hear Shiller's further thoughts.  He makes the interesting analysis of the recent earthquake in Haiti.  As with earthquakes, our models do not yet allow us to predict when an economic crisis will occur.  And even if we could, that would not be the most important information.  The most important information is knowing how a country, region or city will handle the carastrophe when it does strike, which it inevitably will.  The inference is thus that economics should be refocused on providing economic "health checks."  As there systemic vulnerabilites in an economy's ability to weather a crisis may be similar to the same characteristics that bring on a crisis, this practice if rigorously carried out may prove preventitive too.

@dhlii:

There can be no invisible hand with government, they always create distortions.  And at the same time, the market needs them too.  Read Milton Friedman more closely and you'll see that the great free market economist himself calls on governments to correct disequilibrium situations. 

FTMMFA;

   I have read Hayek rather than Friedman. My argument is that the recession/depression is the action of the invisible hand correction for the distortion of the invisible hand. I am not familiar with Friedman's arguments for government action but within the classical liberal tradition the rationale for government intervention must be non-economic - and must accept that the economic effects of government action will be net negative. Rather that correcting dis-equalibrium, government needs to pay more attention to not creating it.

   Haiti and Chile should provide lessons. Disasters natural or otherwise can occur anywhere, and anytime. The impact of the disaster is more closely tied to the existance and strength of the institutions.

Here's my theory--I think that when a market is over-heated, what is ratinal for each individual is irrational for the group as a whole. It is like being in a crowded theatre that has caught on fire. For each individual, the best thing to do is to run to the exit as quickly as possible, but if everyone does that, it will ruin the chances of escape for everyone. When house prices were rising by the day, when banks could sell a mortgage on to someone else, when everyone was making money by doing thingts that they knew were crazy, there is no way a rational person, guided by the need to maximize her own profit, can sit it out. Any money manager who wasn't investing in crazy stuff was losing money for his clients. So everyone is somehow forced to act in a way that is ultimately destructive--unless there is a power higher than individual financial self-interest to stop them.

Does anyone remember the movie "They Shoot Horses Don't They?" IN that dance contest, held in the depression years, competitors were forced to dance faster and faster because everyone else had to because whoever danced fastest would win--although if everyone had slowed down it would have been better for all of them.

Without effective counter-pressure from something outside the market, every market will self-destruct.

Evelyn;

    I think you are looking at the wrong end of the problem.  First there i increasing evidence that the majority of people do not panic nearly as often as we beleive, nor enmasse, under dire circumstances. Most tragic fires kill large numbers because - exiting is inaddequate or worse exits are locked, the fire spreads fast, and most people are killed by smoke long before the fire gets them.

     What was the rational response to circumstances in early fall 2008 ? I wish I had been wise enough to sell all the stock I owned in a panic, and bought it back in January 2009.

      Regardless, most of what home buyers, banks, markets, were doing throughout this was a rational response to circumstances.

The fundimental problem was not that risky mortgages were being written - both good and bad business decisions are made everyday, and the vast majority of businesses can survive a number of small mistakes.

The key issue was that everyone was moving in the same direction.

Government put its thumb lightly and deliberately on the scales. The result was exactly as desired, but the unintended consequence was a small shift in the distribution of risk. Compound something small over enough years and it becomes large. A separate but related unintended consequence increased the cost of housing a small amount more than would have occured otherwise. Again compounded over several years. The Feds monetary policies did not help. It is even possible that if the Fed had acted early to burst the housing bubble the carnage might have been reduced. 

  Further, business mostly responded rationally to all of this. Banks changed from writing and holding to writing and selling mortgages. Mortgages were "securitized" to distribute risk - though distributing was confused with reducing. Banking rules encouraged using securities for capitol, and compounded the error by misvaluing the securities. Banks did not actually become insolvent, they became illiquid.

   Markets are people, and they make mistakes - everyday. sometimes ones that are individulally catastophic. But creating the amplifying feedback system that causes the artificial or exagerated booms that devestate when they burst requires the external force of government.

dhli: Markets are people, and they make mistakes - everyday. sometimes ones that are individulally catastophic. But creating the amplifying feedback system that causes the artificial or exagerated booms that devestate when they burst requires the external force of government.

Markets are people and poeople make mistakes--agreed. But the effect was not caused or exacerbated by government interference. On the contrary, if the government had played the role of grown-up in a room full of 3-year-olds, they could have prevented the worst effects of market forces. Evidence? Well, from 1932 to the 2000s, the government had controls that prevented serious crises. And when those controls were lifted, we are right back to the latter part of the 19th and early part of the 20th century--crisis and disaster.

(1) Richard Feyman once remarked that if we can't make a topic understandable to freshmen, we don't really understand it.

(2) Software project managers have already given up "long term" estimation, planning etc.

(3) Once Konosuke Matsushita was asked how he predicted so well. He replied by noting this bservation: It was the oned with good eyse who fall badly, but the blind seldom fall so badly.

I hope this realization at least will keep the policy makers honest and humble.

EthicMinds

george kyaw naing

Evelyn;

   Get beyond the fallacious grade school versions history. Capitolism has existed for 1/4 of a millenium. During that time humanity has improved more by every measure than during the entire rest of history. The only economic distinction of consequence between the 19th and early 20th centuries and 1932-2000, is the introduction of inflation - which can only be caused by governments. There is a great deal of disagreement on the causes and cures of the grat depression - but I am not aware of anyone credible who still attributes its causes to the market or its cure to the progressive policies of Hoover and FDR. Nor am I aware of anyone who does nto attribute the economic mess of the late 60's through the 70's solely to government.

    Within the past thirty years the improvement in the standard of living worldwide has been phenominal. The greatest improvements have been in those countries with the greatest decrease in government economic control. followed by countries that have the least government economic control.

    The capitolist world has great disparity, but solely measured by the state of the poor one would chose to eschew government.

    Much of what Adam Smith told us 250 years ago is still true. The political and economic outcome of Free Markets are most pronounced and positive at the bottom. The real objective of government interference is supressing upward mobility and preserving the status quo.

    But don't take my word for anything. Check out worldwide standards of living, how, when and where they have improved - rather than accept some doctrinaire version of history given to you by others.

     Rather than persuing policies that make us feel good, maybe we should chose those that have actually worked.