Crisis and the Failure of Economic Theory

The contemporary economic crisis is an extraordinary opportunity to test the relevance of economic theory. The first lesson to be learnt from this crisis is that economic theories are not abstract constructions, extraneous to the real world, but they produce significant consequences for the welfare of a society. In other words, economic theories can cause crises. Giancarlo Bertocco explains.

According to the mainstream theory, developed after the stagflation of the 1970s, in a market economy in which the price system is free to work without major obstacles, a disastrous crisis, such as the recent one, cannot occur. The adoption of a theoretical model which maintained that market economies are structurally stable implied, of course, that the economists were not able to predict the onset of a catastrophic crisis. This is why public opinion has fiercely criticized the economics profession. Nevertheless, the economists’ responsibilities go beyond their inability to foresee the crisis since, by elaborating a theoretical model which ruled out the occurrence of this event, the economics profession enabled the paralysis of the financial system and the subsequent Great Recession. In fact, this theory led the vast majority of economists to neglect the signs of instability that emerged during the Great Moderation and provided the theoretical endorsement for the behaviors and choices that created the conditions for the outbreak of the crisis.

The second lesson that we, as economists, should learn from the current crisis concerns the limitations of the mainstream economic theory developed over the last 40 years. However, almost ten years after the outbreak of the crisis, most of the economics profession continues to accept the mainstream theoretical model. There is a deep contradiction between a theory that denies even the possibility of a deep crisis and the factual reality. This contradiction becomes apparent if one looks at the explanations of the crisis elaborated by mainstream economists. In fact, it is not easy to identify the origins of the crisis by using a theoretical model which states that market economies cannot be subject to significant turbulences.

The first part of our new book Crisis and the Failure of Economic Theory shows that, in order to explain the causes of the financial crisis and the subsequent Great Recession, mainstream economists are forced to use concepts and relationships that are inconsistent with the dominant theory. The deep contradiction between the analysis of the origins of the crisis made by conservative economists and the mainstream theory, highlights the inability of most of the economics profession to explain the functioning of modern economic systems and the need to develop an alternative theoretical model.

The third lesson that economists should learn from the crisis concerns the necessity of developing a new theoretical approach that can provide a sound explanation of the phenomenon of economic crises and of the role of finance in modern market economies.

The development of an alternative theory is discussed in the second part of this book, focusing on the ideas of a group of ‘heretical’ economists such as Marx, Keynes, Schumpeter, Kalecki, Kaldor and Minsky. In order to develop what Keynes called a Monetary Theory of Production, a special emphasis is placed on the need to recover the elements of Keynes’s work that were neglected by the advocates of the Neoclassical Synthesis. The book shows that Schumpeter’s analysis of the role of credit is essential to explain Keynes’s insights concerning: 1) the importance of uncertainty; 2) the principle of effective demand; 3) the importance of the process of wealth accumulation and of the phenomenon of speculation; and 4) the structural instability of modern market economies.

Economic crises, like earthquakes, are not predictable

The third part of the book emphasizes two specific aspects of the endogenous nature of the current crisis. First, it shows how the same factors described by Schumpeter as characterizing the development of capitalist economies also explain the economic systems’ inherent instability and their tendency to be exposed to deep crises. Secondly, it points out that the endogenous nature of the current crisis does not imply that, like earthquakes, it is necessarily an unavoidable event. The equivalence between economic crises and earthquakes has been frequently used by economists to defend the category against the accusation of their alleged inability to anticipate what was going on: economic crises, like earthquakes, are not predictable.

This metaphor is not at all convincing because, while earthquakes are natural events, economic crises are the outcome of social dynamics. This difference has major consequences. In fact, earthquakes are not only unpredictable but also inevitable. This means that the probability of their occurrence is completely independent of the theories developed by seismologists to explain their origin. This is not true for economic crises, as the likelihood of their occurrence is not at all independent of the way economists theorize the functioning of a market economy.

The analysis of the nature of the current crisis is not only a matter of academic interest, but also has important consequences on the definition of the policies needed to overcome it. The last part of the book shows that the fundamental limitation of the policies proposed by the mainstream economists consists in the fact that they are designed on the basis of the economic system described by the mainstream macroeconomic theory (i.e. a system in which the contemporary crisis could not have happened). Paradoxically, these policies originate from the same theoretical model that contributed to cause the Great Recession. This contradiction can only be eliminated by developing policies that are consistent with the structural nature of the contemporary crisis.

Giancarlo Bertocco is Associate Professor of Monetary Economics in the Economics Department at the University of Insubria, Italy

Crisis and the Failure of Economic Theory: The Responsibility of Economists for the Great Recession by Giancarlo Bertocco is out now.

Read Chapter 1: A Brief Description of the Crisis free on Elgaronline.