The financial crisis: Why did no-one see it coming, and why did economists get it so wrong?

Why didn’t the experts see it coming?, asked the Queen of England, and the British Academy wrote a letter to explain. Of the lead up to the global financial crisis they wrote:

“It is difficult to recall a greater example of wishful thinking combined with hubris.”

Meanwhile, economist Paul Krugman asked a similar question – how did economists get it so wrong –  and came up with an answer to do with the difference between salt water and fresh water (apparently one turns you Keynsian and the other turns you neo-classical). Krugman noted the failure  of neoclassical economics to account for the apparent irrationality of the market, and proposed as a remedy the emerging sub-discipline of behavioural economics.

When it comes to the all-too-human problem of recessions and depressions, economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly.

Both these approaches – that of the British Academy highlighting wishful thinking and hubris, and that of behavioural economics highlighting cognitive biases – make the great mistake of assuming that there is a single ‘ideal’ rationality,which real humans happen to be incapable of attaining. Continue reading “The financial crisis: Why did no-one see it coming, and why did economists get it so wrong?”