Economists and the Financial Crisis: What were they thinking?

Matias Vernengo

The role of ideas in promoting the financial crisis has been often disregarded.  It seems as if the development of complex financial instruments and the deregulation of financial markets have taken place in an economic thinking vacuum.  However, the opposite is the case, and modern finance developed and taught in the finance and economic departments, particularly of business schools, has been central for creating the conditions for the current crisis. Esteban Pérez-Caldentey and I deal with the issue in a recent paper published in the Real World Economic Review.

Modern finance sought to provide a ‘scientific foundation’ for the action and behaviour of economic agents. The scientific foundation expressed in hypothesis — such as that asset prices move randomly, that returns are stationary, that risk and return have a definite linear relationship, that finance can, under very specific assumptions, be irrelevant to investment decisions, or that it is always possible to create a risk-free portfolio — gave legitimacy to capital and stock market activity within a free market economy. It proved that no agents could obtain ‘excess’ profits within this institutional framework and the creation of a pyramid of financial assets and innovation was a good thing, as it could eventually lead to the elimination of risk.

Those views have been institutionalized by the astonishing growth of MBA programs. In the mid-1950’s, the annual output of US business masters was a little over 3,000. Close to three decades later, in 1981, the number of business master’s degrees reached 55,000. By 1997-1998, the number had expanded to reach over 100,000. In comparative terms to other professions, the number of MBA degrees surpassed the combined output of Lawyers and Medical Doctors in 1980, and in 2000 doubled the BAs awarded in engineering.

The solution to the current crisis would involve not only significant reform of financial institutions and practices, and more stringent regulations, but also a rethinking of the theories taught by finance departments.  If that does not happen, in the future Universities will have to apologize for their Finance departments, as much as the Catholic Church apologized for the Holy Inquisition.

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