[p2p-research] Stiglitz: Needed: a New Economic Paradigm

[Ryan]

  Sent to you by Ryan via Google Reader: Stiglitz: Needed: a New
Economic Paradigm via Economist's View by Mark Thoma on 19/08/10

Joseph Stiglitz says adding bells and whistles to the current vintage
of macroeconomic models will not fix what is wrong with them, "Nothing
less than a paradigm shift will do":
Needed: a new economic paradigm, by By Joseph Stiglitz, Comentary,
Financial Times: The blame game continues over who is responsible for
the worst recession since the Great Depression – the financiers who did
such a bad job of managing risk or the regulators who failed to stop
them. But the economics profession bears more than a little
culpability. It provided the models that gave comfort to regulators
that markets could be self-regulated; that they were efficient and
self-correcting. The efficient markets hypothesis ... ruled the day.
Today, not only is our economy in a shambles but so too is the economic
paradigm that predominated in the years before the crisis – or at least
it should be. It is hard for non-economists to understand how peculiar
the predominant macroeconomic models were. Many assumed demand had to
equal supply – and that meant there could be no unemployment. (Right
now a lot of people are just enjoying an extra dose of leisure; why
they are unhappy is a matter for psychiatry, not economics.) Many used
“representative agent models” – all individuals were assumed to be
identical, and this meant there could be no meaningful financial
markets (who would be lending money to whom?). Information asymmetries,
the cornerstone of modern economics, also had no place: they could
arise only if individuals suffered from acute schizophrenia, an
assumption incompatible with another of the favored assumptions, full
rationality. Bad models lead to bad policy: central banks, for
instance, focused on the small economic inefficiencies arising from
inflation, to the exclusion of the far, far greater inefficiencies
arising from dysfunctional financial markets and asset price bubbles.
After all, their models said that financial markets were always
efficient. Remarkably, standard macroeconomic models did not even
incorporate adequate analyses of banks...: even a cursory look at the
perverse incentives confronting banks and their managers would have
predicted short-sighted behavior with excessive risk-taking. ...
Fortunately, while much of the mainstream focused on these flawed
models, numerous researchers were engaged in developing alternative
approaches. ... With a few exceptions, most central banks paid little
attention to systemic risk and the risks posed by credit interlinkages.
Years before the crisis, a few researchers focused on these issues,
including the possibility of the bankruptcy cascades that were to play
out in such an important way in the crisis. This is an example of the
importance of modeling carefully complex interactions among economic
agents (households, companies, banks) – interactions that cannot be
studied in models in which everyone is assumed to be the same. Even the
sacrosanct assumption of rationality has been attacked: there are
systemic deviations from rationality and consequences for macroeconomic
behavior that need to be explored. Changing paradigms is not easy. Too
many have invested too much in the wrong models. Like the Ptolemaic
attempts to preserve earth-centric views of the universe, there will be
heroic efforts to add complexities and refinements to the standard
paradigm. The resulting models will be an improvement and policies
based on them may do better, but they too are likely to fail. Nothing
less than a paradigm shift will do.
But a new paradigm, I believe, is within our grasp... What is at stake,
of course, is more than just the credibility of the economics
profession or that of the policymakers who rely on their ideas: it is
the stability and prosperity of our economies.

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