Conway says the crisis has been “an earthquake for economic thought” and Lilico says we need “new theories.“ This, though, seems to regard economics as a settled but inadequate body of knowledge and theory. It’s not. It is instead a vast number of diverse insights. What’s more, all of the insights that help explain the current economic crisis were, in truth, well known to economists before 2007, for example:
1. Risk cannot be simply described by a bell curve. But we learnt about tail risk on October 19 1987. And we learnt from the collapse of LTCM in 1998 that correlation risk, liquidity risk and counterparty risk are all significant.
2. Assets can be mispriced. But we’ve known about bubbles for centuries - since at least 1637. Their existence does not disprove the efficient market hypothesis; as I’ve said, the EMH is not the rational investor hypothesis. Nor, contrary to Conway’s implicit claim, is the EMH inconsistent with the possibility that behaviour can be swayed by emotions; the EMH allows for the possibility of time-varying risk premia*.
3. Long periods of economic stability can lead to greater risk-taking. We’ve known this since (at least) Hyman Minsky.
4. Banks can suffer catastrophic losses - which are correlated across banks. We learnt this - not for the first time - in the Latin American debt crisis of the early 80s and in the crises in Japan and the Nordic countries in the early 90s. Banking crises are a regular feature of even developed economies.
5. Institutions, such as banks, can be undermined by badly designed incentives. But there’s a huge literature on the principal-agent problem.
The current crisis, then, has not thrown up much that economists didn’t know.
Instead, our problem is a different one. It’s that what we have are lots of mechanisms, capable of explaining why things happen and the links between them. What we don’t have are laws which generate predictions. In his book, Nuts and Bolts for the Social Sciences, Jon Elster stressed this distinction. The social sciences, he said:
What’s more, I am utterly untroubled by this. The desire for such laws is as barmy as the medieval search for the philosopher’s stone. If you need to foresee the future, you are doing something badly wrong.
* The basic insight of efficient market theory is that you cannot out-perform the market except by taking extra risk. I am sick and tired of hearing people who still have to work for a living trying to deny this.