How Did Economists Get It So Wrong?
nyt.com

"Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. [...] (T)he central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess."

"The elegance and apparent usefulness of the new theory led to a string of Nobel prizes for its creators [...]. Armed with their new models and formidable math skills — the more arcane uses of CAPM require physicist-level computations — mild-mannered business-school professors could and did become Wall Street rocket scientists, earning Wall Street paychecks."

"(T)here was something else going on: a general belief that bubbles just don’t happen. What’s striking, when you reread Greenspan’s assurances, is that they weren’t based on evidence — they were based on the a priori assertion that there simply can’t be a bubble in housing.[...] In short, the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in inflating that bubble in the first place."

"If [economics] is to redeem itself, it will have to reconcile itself to a less alluring vision — that of a market economy that has many virtues but that is also shot through with flaws and frictions. [...] What’s probably going to happen now is that flaws-and-frictions economics will move from the periphery of economic analysis to its center."

“'The market can stay irrational longer than you can stay solvent.' As pointed out, arbitrageurs — the people who are supposed to buy low and sell high — need capital to do their jobs. And a severe plunge in asset prices, even if it makes no sense in terms of fundamentals, tends to deplete that capital. As a result, the smart money is forced out of the market, and prices may go into a downward spiral."

"The vision that emerges as the profession rethinks its foundations may not be all that clear; it certainly won’t be neat; but we can hope that it will have the virtue of being at least partly right."

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