Risky Risk Management

LONDON – Mainstream economics subscribes to the theory that markets “clear” continuously. The theory’s big idea is that if wages and prices are completely flexible, resources will be fully employed, so that any shock to the system will result in instantaneous adjustment of wages and prices to the new situation.

This system-wide responsiveness depends on economic agents having perfect information about the future, which is manifestly absurd. Nevertheless, mainstream economists believe that economic actors possess enough information to lend their theorizing a sufficient dose of reality.

The aspect of the theory that applies particularly to financial markets is called the “efficient market theory,” which should have blown sky-high by last autumn’s financial breakdown. But I doubt that it has. Seventy years ago, John Maynard Keynes pointed out its fallacy. When shocks to the system occur, agents do not know what will happen next. In the face of this uncertainty, they do not readjust their spending; instead, they refrain from spending until the mists clear, sending the economy into a tailspin.

It is the shock, not the adjustments to it, that spreads throughout the system. The inescapable information deficit obstructs all those smoothly working adjustment mechanisms – i.e., flexible wages and flexible interest rates – posited by mainstream economic theory.