Most every economist agrees that markets are not perfect.  Public goods like basic research need to be financed by government. The results of basic research generally have very little commercial value, but can have enormous societal value when they feed into applied research and product development.  Theoretical economics is one such example of basic research.

But public research budgets should not finance any old thing.  They should finance national research priorities.  Same goes for theoretical economic research.  It should serve society, not just entertain economists.

As the world descends further and further into this financial crisis, one can wonder whether economists are actually doing their job properly.  This is the question tackled in a recent working paper issued by the Kiel Institute for the World Economy entitled "The Financial Crisis and the Systemic Failure of Academic Economics".  

The Kiel authors note that most economists were not aware of the long build-up to the global financial crisis, and then under estimated its dimensions once it hit.  They argue that this is because economists' models are not equipped to analyse the drivers of asset and financial markets, despite the regularity of boom-bust cycles. These models do not capture the inherent dynamics of economic systems and the instability that accompanies the complex dynamics.  This represents a "systemic failure of the economics profession". 

Economists like Bagehot (1873), Leijonhuvfud (2000), Kindleberger (1989) and Minsky (1986) have studied crisis phenomena.  But their work is largely ignored!

One key aspect of the crisis was the dramatic rise in markets for structured products like collateralized debt obligations and credit default swaps.  The properties of these products was estimated using mathematical models estimated using data from periods of low volatility (until now, US nationwide housing prices had not fallen since the Great Depression).  No wonder they turned out to be so risky!

"Rational expectations" is another key assumption of most economic models.  They imply that individuals and economists have a complete understanding of the mechanisms of our economies.  Nothing could be further from the truth.  For one, economists have fundamental disagreements on the workings of the economy.  And psychology shows that human behaviour in no way resembles the rational expectations model.  Financial markets are in fact strongly influenced by emotional and hormonal reactions!

Connectivity in the financial system has grown enormously over the past decades.  And as the natural sciences show, a more connected system may be more efficient in some ways, but will also make a system more vulnerable to shocks.  And while computer science and operations research have undertaken systematic analysis of network vulnerability, this is not the case for financial economics!   

The authors of course recommend that the economics profession apply itself to the research agenda of financial fragility.  And what's more they argue that economists should have an "ethical responsibility to communicate the limitations of their models and the potential misuses of their research".

In reality, most of the world's most successful economists are fighting to get the ear of policy makers, to receive fat research budgets and to achieve personal fame.  As important as it is, the ethical responsibility agenda will be a tough nut to crack. 

Reference:

"The Financial Crisis and the Systemic Failure of Academic Economics" by David Colander, Hans Follmer, Armin Haas, Michael Goldberg, Katarina Juselius, Alan Kirman, Thomas Lux, and Brigitte Sloth.  Kiel Working Papers.  Kiel Institute for the World Economy.  www.ifw-kiel.de