The most terrifying moment in modern economic history occurred two years ago this month. For several long days after the fall of Lehman Brothers on Sept. 15, 2008, the financial system was in danger of total collapse, and the United States seemed on the precipice of another Great Depression in that “Black September.” Just as bad, our economists and senior policymakers had barely any idea why this was happening.
The assumptions of an entire era had been proved wrong. The “Great Moderation”—the period of post–Cold War prosperity in which capitalism was said to have been tamed and risk mastered—was revealed to be an illusion. Alan Greenspan professed his “shocked disbelief” that the Wall Street institutions he had trusted in were so reckless as to blow themselves up. “The whole intellectual edifice has collapsed,” the former Fed chairman told Congress that fall. Economists said they would have to come up with new theories for how markets worked, in particular how the financial system functioned and interacted with the “real” economy. “Large swaths of economics are going to have to be rethought on the basis of what happened,” Larry Summers, the presidential adviser who doubles as a world-renowned economist, told me in an interview shortly after Barack Obama took office.
Two years on, that rethinking has barely begun, and only with the most painful reluctance by economists. Meanwhile, policy and political debates still driven by outdated economic theory have been racing out of control, bitterly dividing the nation. Whether the arguments are about stimulus, financial reform, health care, or jobs, the discussions in Washington tend to be dominated by simplistic black-and-white views that are little different from the conceptual framework that prevailed before the collapse: markets always work better than governments. Advocates of government spending are socialists. Champions of markets are laissez-faire ideologues or slaves of Wall Street. And never the twain shall meet. A vast new regulatory framework has been set in motion, but many experts say it has done little to change the way Wall Street or the real economy functions, and there is no new economic theory underlying it.
The failure of the economics profession to address our deeper problems theoretically is mirrored by the failure of other sciences on a more practical level. To wit: America’s best minds are still heading to Wall Street to an unnerving, even pathological degree—further evidence that finance remains the dominant sector of the economy. The evolution of the financial sector’s trading and banking practices into arcane rocket science in recent decades had a lot to do with…rocket scientists. After the end of the Cold War and the collapse of the Soviet Union in late 1991, top physicists and engineers and other major-league brains weren’t needed as much. With the advent of the “peace dividend” (read: Pentagon cuts), many of them headed for Wall Street and became “quants.” This trend brought two new, big things to Wall Street: a whole-new level of intellectual horsepower—the upper reaches of the IQ scale—and a new layer of important players who had no reason to doubt that markets worked as formulaically as the weapons systems they had once puttered over. That’s partly how “structured finance,” derivatives, and other products have grown so complex that not only regulators but even Wall Street CEOs can no longer understand them.
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