Nearly five years ago, when we were facing what appeared to be the collapse of the financial system and mainstream economic theory, there was the distinct feeling that we were on the verge of an epochal change.
The spectacular failure not only of the predominant type of capitalism but also of its very legal and social structure and theoretical background gave many the hope of a new dawn. Similar to what happened in the aftermath of the Great Depression, there was the expectation that the role of the financial sector would be redefined and that economic theory would be reshaped.
Five years on, there are reasons to be optimistic and one reason to be pessimistic.
Let me start with the good news. The widely recognized necessity for stricter regulation of financial speculation has indeed produced results, particularly in the U.S. and in Europe. Banks’ capital requirements have been raised (up to 6% in the U.S.). Financial institutions progressively adjusted their capital structure to reflect a lower reliance on short-term and risky financing. The debate around the role of the financial sector has also led to a discussion about the size of bonuses for bank managers, which will be regulated and limited in the E.U. At the same time, mainstream economic theory has become more permeable to elements of non-orthodox thought.
After what seemed to be a long sleep, many academic economists woke up and started to consider debt in their models not just as a neutral reallocation of financial resources. The current standard DSGE models regularly feature a financial sector, heterogeneous households and firms, and, to a variable extent, limits in the cognitive capacity of agents. The potentially destabilizing role of the endogenous creation of credit is taken more seriously and, consequently, the necessity of more active role for central banks (not merely limited to the containment of inflation) is now an important part of the economic discussion. Arguably, this evolution would have taken place in any case, but the Great Recession significantly accelerated the process.
But the improvements in both financial regulation and economic thinking suffer from the same limitation. The lack of a systemic and holistic vision risks undermining any progress and preparing the ground for the next crisis.
On the regulation side, even the interventions mentioned above do not embody a different conception of the financial sector, aimed at redefining its role within a capitalist economy. They rather look like a patchwork of ad-hoc measures with the modest aim to limit the effects of another period of financial distress. This limited vision runs the risk of failing to prevent a new cataclysm in the long or medium term. It also dramatically fails to address other urgent issues, since capital requirements and other regulation of capital structures are not likely to improve the structure of the financial system (as a series of studies based on network theory recommend). Nor will they avoid the concentration of assets and the moral hazard problem that arises from the “too big to fail,” or “too interconnected to fail,” institutions.
In the same fashion, the incorporation of external elements in the mainstream neoclassical-new Keynesian theories did not affect their core. Methodological individualism and the spontaneous tendency to a general equilibrium (of the system and of its components) are still the pillars of the current models.
Essential features of an economic system have not yet found a place in mainstream models. One example is the role of dynamic interactions that happen at the micro level and lead agents to modify their expectations and behaviors without coordination. Another example is the persistence of disequilibrium at the aggregate level and the possibility of self-sustaining explosive dynamics.
Additionally, the emergence of inequality is still regarded as a moral issue and its potentially devastating economic consequences are not deemed worthy of investigation. Disregard for these and other essential factors makes the improvements mentioned above look merely cosmetic and fashionable. In all likelihood, the same forces that opposed a more radical reform of financial institutions also opposed a refoundation of mainstream economic theory, given the revolving door between the U.S. financial sector, academia, and government bodies.
This lack of ambition makes me wonder not if a new meltdown can happen, but when.