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Let A Hundred Theories Bloom

BUDAPEST – The economic and financial crisis has been a telling moment for the economics profession, for it has put many long-standing ideas to the test. If science is defined by its ability to forecast the future, the failure of much of the economics profession to see the crisis coming should be a cause of great concern.

But there is, in fact, a much greater diversity of ideas within the economics profession than is often realized. This year’s Nobel laureates in economics are two scholars whose life work explored alternative approaches. Economics has generated a wealth of ideas, many of which argue that markets are not necessarily either efficient or stable, or that the economy, and our society, is not well described by the standard models of competitive equilibrium used by a majority of economists.

Behavioral economics, for example, emphasizes that market participants often act in ways that cannot easily be reconciled with rationality. Similarly, modern information economics shows that even if markets are competitive, they are almost never efficient when information is imperfect or asymmetric (some people know something that others do not, as in the recent financial debacle) – that is, always .

A long line of research has shown that even using the models of the so-called “rational expectations” school of economics, markets might not behave stably, and that there can be price bubbles. The crisis has, indeed, provided ample evidence that investors are far from rational; but the flaws in the rational expectations line of reasoning—hidden assumptions such as that all investors have the same information—had been exposed well before the crisis.