There is no doubt that the standard economic theory of human psychology is crude, even laughable. So much so that the real surprise is that it turns out to be as useful as it is! Maximising convex "utility functions" is not much to go on.
So behavioural economics and the like are welcome developments. My own judgment is that, so far, it has not amounted to very much--certainly not the revolution some had hoped for. Still, it is early days and the live policy experiments implemented by the Obama administration should provide good grist for the analytical mill.
From the point of view of Davies' column, I would say the most interesting areas of application would be in the investgation of organizations (How do banks work so that, collectively, highly skillied and talented people drive the bank off a cliiff? How can incentives or organizations be changed to stop this? How do supervisory institution managers convince themselves that, aginst all evidence, that things are fine, and how can their incentives be changed?), and how psychology affects or causes financial market bubbles.
It is of course understandable that everyone is taking the opportunity of the greates economic crisis in 80 years to pile onto economics and economists. Still, the tone of Davies' effort is surprising, coming as it does from the former head of the FSA, an organization that more than most must shoulder the blame for the financial meltdown that triggered it. I would have expected something more along the lines of confession and abject apology for such now-infamous policies as "light-touch" banking supervision.
As to the substance, three points. First, forecasting, and especially forecasting very unusual events, is very difficult--maybe impossible. As economists, or climate scientists (about, say, hurricanes), or geologists (about, say, earthquakes), or engineers (about, say, collapsing bridges). Of course, all these disciplines should try harder. But I, for one, am not holding my breath for significant improvements.
Second, contrary to what Davies seems to believe, lots of people (even many economists) were increasingly worried about the debt and housing bubbles that built up on the 2000s. Many warned that US house prices were likely to fall. many warned of the weakness of mortgage underwriting. Many warned of rising household debt. Most, it is true, did not predict the greatest recession since 1929. And I suspect that most of those that did were more lucky, or just naturally pessimistic, than smart. Unfortunately, the policy-making apparatus, especially in the US but also in the UK (remember the light touch?), had been captured by those who thought markets could do no wrong, and who therefore chose to do nothing.
Third, the policy response--which I think was the best that could be done once the crisis took hold--was textbook, mainstream macro. Basically, monetary and fiscal stimulus to raise demand, and support for the financial sector. 1929 did not happen. Not all policymakers were fully on board, mind you. Trichet, a holdover from the old regime, resisted both as much as he could, even disastrously raising interest rates at one point. King was also slow to pull the trigger. Now, they complain that they received no "help". In fact, the help was in front of their noses, but they need an excuse to explain away their bungling.
Finally let me say that Davies is right. Economists have been faced with a near-unprecedented situation, and it should take it as an opportunity to learn and to expand their knowledge. How economics will move forward is anyone's guess. Appeal to hoary and discredited theories is a waste of time (Marxists and Austrian theorists, this means you). Obvious candidates: how financial amd real markets interact (the IS-LM model has a bit of this, but surely there is more); how stocks and flows interact (ditto); how generalized excess demand comes about; multiple equilibria (that is, non-linear economics).
Third, on the policy front, standard macroeconomic principles