A remarkably distinguished group of economists gathered last weekend for the inaugural conference of the Institute for New Economic Thinking, an initiative of George Soros. They were soul searching over the failures of economics in the recent crisis. Such failures are most evident in two areas: the inadequacies of the efficient market hypothesis, the bedrock of modern financial economics, and the irrelevance of recent macroeconomic theory.
The central idea of the efficient market hypothesis is that prices represent the best estimate of the underlying value of assets. This thesis has recently taken a battering. The boom and bust in the money markets was precipitated by a US housing bubble. That bubble followed the New Economy fiasco and was preceded by the near-failure of Long Term Capital Management, a hedge fund designed to showcase sophisticated financial economics.
The macroeconomics taught in advanced economics today is largely based on analysis labelled dynamic stochastic general equilibrium. The unappealing title gives the game away: the theorists are mostly talking to themselves. Their theories proved virtually useless in anticipating the crisis, analysing its development and recommending measures to deal with it.