A new kind of financial model could avert another crisisby Philip Ball / July 21, 2010 / Leave a comment
Published in August 2010 issue of Prospect Magazine
Critics of conventional economic theory have never had it so good: the credit crunch has left orthodox thinking, embraced by most of the establishment, a sitting duck. But can alternative economic models help us to anticipate such crises, or better manage them? In short, can the “dismal science” be made truly scientific?
In summer 2007 Frederic Mishkin, a governor of the Federal Reserve, forecast that the banking problems triggered by stagnation of the US housing market would be a minor blip. His prediction was based on the most orthodox theoretical framework: dynamic stochastic general equilibrium (DSGE) models. The subsequent near-collapse of the global market represents the kind of failure that would have buried any theory in the natural sciences. But it has not done so here. Why? Nobel laureate Robert Lucas explains that the theory is explicitly not designed to handle crashes, so of course it will not predict them. That’s not a shortcoming of the models, Lucas says, but a reflection of the fact that crashes are inherently unpredictable by this (or any other) theory.