1 - The Power and Pitfalls of Theory

Summary

Introduction

There is nowhere to hide. What began as a crisis in the subprime sector ($2.5 trillion in size) of the U.S. housing industry in mid-2007 set the whole financial industry globally on fire and subsequently sucked the world economy into a global recession with growth rate of 3.1 per cent in 2008 and negative 1.4 per cent in 2009 (IMF 2009b). The implosion of the U.S. subprime mortgage industry has affected every asset class — from equities to bonds, from money markets to commodities; every type of credit — from mortgages to credit cards, to auto and student loans, to corporate debt and leveraged buy-outs; and every country that is integrated into the world financial system from Australia to Tokyo to Uzbekistan. The collapse of two Bear Stearns’ hedge funds that invested in subprime collateralized debt obligations (CDOs) is the trigger of the crisis; it is not the cause.

The causes or origins of this crisis should be analysed at three inter-related levels — the theory and methodology underpinning the disciplines of neoclassical economics, finance and risk management; their influence on the evolution of the financial industry and poor regulatory practices; and the fundamental structural changes in the U.S. and international economy and the resulting major macroeconomic imbalances.

This chapter traces the roots of the crisis to the theoretical and methodological flaws in market efficiency theories that form the foundation of finance and risk management and how they contributed to the crisis.

Evolution of Macroeconomic Theory of Market Efficiency

Modern macroeconomics was born out of the Great Depression. In fact Ben Bernanke, the current Federal Reserve chairman, wrote in 1995 that “not only did the Depression give birth to macroeconomics as a distinct field of study, but … the experience of the 1930's continues to influence macroeconomists’ beliefs, policy recommendations, and research agendas” (cited in Koo 2008, p. xi). Keynes in “The General Theory of Employment, Interest, and Money” (1936, republished 1964), set out not only to explain the Depression but also constructed a new edifice for explaining the workings of, and interplay between the financial sector and the real economy. The Keynesian theory held sway for decades until the 1970s when it met difficulties in explaining the phenomenon of stagflation.