Financial Crises and the Neoclassical Lullaby of Equilibrium

Note: The views expressed by the author are not necessarily those of CSEP Committee members or the society as a whole.

When I started studying economics in the autumn of 2008, I thought I had arrived at the right place at the right time. The global economy was on the brink of its largest downturn in 80 years. When I graduated in 2012, the GDP in the Eurozone was lower than when I entered the course. Yet I had learned nothing whatsoever about the economic crises that had taken place in the meantime! I realised that they had been trying to lull me asleep with the lullaby of equilibrium [1]. At the end of my studies, I mustered all my energy in a desperate attempt at a wake-up call.

I discovered that there are many good theories out there that could account for – and even some that predicted – the financial crisis. I was bewildered by the fact that my teachers and textbooks did not mention these perspectives. Were they simply unable to grasp the problem at hand?

The result of my efforts was my master dissertation, in which I asked: Is neoclassical economics – by its very nature – unable to theorise about the causes of financial crises? The answer to this question was ”yes”. Let me explain why.

To answer the question I needed two things: a) an indication of the causes of financial crises and b) a coherent definition of neoclassical economics. (I might now have used the term “mainstream”, but I take the terms to denote the same for the current purposes).

a) The Causes of Crisis

There are some features of the economy that are essential for understanding a financial crisis. First of all, you have to start from the fact that the economy is cyclical and can actually end up in a state of crisis [2]. Crisis is a natural result of how the capitalist economy works. In addition one has to look at the role of fundamental uncertainty, the nature of banks and other financial institutions, and the nature of money and debt.

We do not know what the future will bring! Uncertainty cannot always be quantified as risk, because we do not know the probabilities of future events. We do not have firm knowledge on which to base our expectations of returns from investments, the course of the stock market, etc. We use the past and the present as guides to the future, and we look at what other people think and do. In an uncertain world, changing expectations are a major determinant of economic fluctuations.

Banks are profit-seeking agents (not simply intermediaries). And as many heterodox economists have come to understand: They create the money as well! We should also acknowledge that the institutional structure of the economy might change as a result of expectations. For example, we might see financial deregulation and innovation as a result of persistent over-optimism.

My description of the crisis above draws on different thinkers – from Keynes and Minsky, to Schumpeter, Fisher, and Hayek – and is furthermore, I believe, consonant with common sense. It should not be too controversial, I think.

b) Neoclassical economics

There are many grim portrayals of neoclassical economics, but they tend to list particularly unrealistic assumptions. This allows neoclassical apologists to point to exceptions and hands them an easy excuse not to take the criticism seriously. For dialogue to take place we need a less contentious conception. We should also try to preserve the continuity of the neoclassical approach since its birth in the late 19th century up until today. If there has been a dominant paradigm since then, this must have a core, i.e. there must be a methodology [3] that has governed and still governs theorising and separates “good” theories from “bad”, and hence excludes heterodox approaches. “Methodology” can be understood as “the rules of the game”. What are the rules of the mainstream game?

I compared the critical review of Arnsperger and Varoufakis (2006) and Torsvik (2003) – a (critical but apologetic) Norwegian introductory book – which described the same methodological basis:

  • Methodological individualism: Everything in the economy should be explained as a result of individual choice!
  • Methodological equilibration[4]: When you theorise, look for the equilibrium! Don’t worry whether the economy will actually end up in one.[5]

To this I added Sheila Dow’s (2012: 86-87) conception of

  • Formalism: Put it all into mathematics! (or at least some deductive argument). [6]

These three criteria are, then, what makes neoclassical economics what it is. It is by reference to them that the wheat is separated from the chaff. Any theory that breaks with any of these requirements is a nonsense theory [7].

So how does this methodology stand up against financial crises?

Neoclassical economics and the crisis

Methodological equilibration stands in the way of understanding the economy as in continuous process, which it is obviously is. It is as Fisher said,  “as to assume that the Atlantic Ocean can ever be without a wave”. Standard macro assumes a tendency towards full employment. The ubiquitous Rational Expectations Hypothesis (REH) is based on an assumption of equilibrium as the expected value. Aberrations are due to “random exogenous shocks”. It is shocking! It amounts to saying that fluctuations and crises originate outside the economy – like comets from the sky. This is an equilibrium theory of fluctuations – which should be precisely the opposite of equilibrium (see Blaug for more on this).

In line with methodological individualism, REH assumes that expectations of individuals are formed independently, and they are normally distributed around the mean. People also know the correct model of the economy. This means that on average people are right! The twin of REH in finance theory is the Efficient Market Hypothesis. It professes that deregulation leads to more stability – since there will be more trades and more information. This is spreading the risk. But the course of the market is fundamentally uncertain. Formalism has made the economists neglect this crucial distinction.

The general problem with methodological individualism is that it encourages economists to forget the role of norms and institutions. We cannot then understand how my expectations depend on yours, or why financial innovation occurs due to our joint optimism and risk-seeking. It could also be the reason for neglecting the nature of banking and money.

It seems, then, that the rules of the game inhibit neoclassical economics from forming theories about financial crises. Why else would one build a theory on fluctuations on the premise of stability? We know that our economic system has a tendency to crisis. To paraphrase Keynes slightly: It may well be that neoclassical economics represents the way in which we should like our Economy to behave. But to assume that it actually does so is to assume our difficulties away.

I have not claimed that mainstream economics is wrong, or a futile endeavour. I accept the possibility that this approach might be reasonably defended. The problem is that mainstream economists do not attempt to defend it. Faced with criticism they find a way to wash their hands and look the other way.

I think the problem is institutional and can be remedied by institutional reform. If no economist is brought up to think a single critical thought, the prevailing beliefs will remain unchallenged and harden into dead dogmas. The key lies, then, in the education of economists. The only way the discipline can secure progress is through serious and systematic engagement with opposing ideas. That is why pluralism is important. Meanwhile the lullaby of equilibrium numbs the minds of yet another generation of economists.

Roman Eliassen

Roman Eliassen is a PhD student at Anglia Ruskin University doing research into pluralism in economics. Twitter: @romeliassen

[1] I am borrowing this phrase from Joan Robinson.

[2] In Minsky’s (1982: xi) words: ”(…) Can «It» – a Great Depression – happen again? (…) To answer these questions it is necessary to have an economic theory which makes great depressions one of the possible states in which our type of capitalist economy can find itself.”

[3] I understand the term as what Kuhn (1996: 175) describes as “the constellation of beliefs, values, techniques, and so on shared by the members of a given community”.

[4] Or ”the axiomatic imposition of equilibrium” (Arnsperger and Varoufakis, 2006).

[5] Both sources also mention instrumental individual behaviour as a central precept, but I did not deal explicitly with this in my dissertation.

[6] This resonates well with Tony Lawson’s (2003) definition of mainstream economics as the insistence on the use of mathematical-deductivist methods.

[7] There are many reasons for why this came about, but I won’t deal with that presently. One particularly powerful explanation is Mirowski’s (1989) account of how economics came to adopt the theoretical scheme of physics.

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