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INTRODUCTION
Te fnancial crisis abruptly disrupted a long period of continuous economic
growth and low unemployment levels in developed countries. Along with the
outstanding performance of the Chinese economy and the upsurge of Russia,
Brazil and India, worldwide economic prospects were brilliant. In addition,
infation was under control, world trade was increasing considerably and many
developing countries were escaping from poverty. Moreover, experts did not
forecast any serious trouble in the near future, just some corrections of global
imbalances through a sof-landing process. Te crisis came as a complete sur-
prise.
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People in developed countries, including experts and economists, were
also astonished. Reports on the fnancial crisis issued by the IMF, the World
Bank or the European Union
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repeated the same mantra: the crisis was unex-
pected. Tis approach to the crisis can be resumed as the No one saw it coming
hypothesis. In Chapter 1, we will explain that this hypothesis is incorrect,
because some experts did see it coming and gave very clear warnings about the
devastating efects of the coming crisis, but they were only credited when GDP
and unemployment fgures were worse than the worst warnings.
Te next step was twofold: on the one hand policymakers had to deal with
huge, and to a certain extent, new problems, as we explain in Chapter 5. On the
other hand, there was a search for something or someone to be blamed for the crisis.
Tere were many candidates. Global imbalances had been considered a dangerous
threat because in the long run they are unsustainable. Some countries
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were experi-
encing a housing bubble, the consequences of which are very well known. Financial
innovations created many sophisticated fnancial products whose potential dan-
gers were dif cult to assess a priori, but proved to be harmful. Te deregulatory
swing since the beginning of the 1980s drove many fnancial processes out of the
reach of monetary authorities. Rating agencies failed to adequately measure the
risk of some assets or they did it so on purpose, misleading investors.
In this volume, we envisage the problem from another point of view. We have
been working on the study of the allocative process from a non-orthodox per-
spective. We believe that mainstream economics has been very fruitful in dealing
with some issues regarding allocative processes, while others remain out of its
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2 Financial Crisis and the Failure of Economic Teory
reach.
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Generally speaking, mainstream economics focuses on economic pro-
cesses that take place close to equilibrium, or it supposes that equilibrium almost
always prevails. Keynesian economics, broadly speaking,
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and Austrian econom-
ics are more prone to a perception that the economy is seldom in equilibrium.
So, we believe that the dominant economic theory before the crisis was not as
complete as it seemed to be. Te fnancial crisis forced us to revise this concern.
No one can hold that dominant economic theory had no responsibility in the
inability to explain and predict the crisis because policymaking and regulatory
activities before 2007 were conducted relying on mainstream economic models.
Tis fact reaf rmed the idea that such models had to be revised. Tis was the
starting point of this book.
Economic theories and economic paradigms more generally difer
because of their assumptions regarding the three building blocks of every eco-
nomic paradigm: the principle of economic behaviour, the characterization of
the agents and the operational environment. For instance, classical and neoclas-
sical and Austrian economics believe that prices are fexible while Keynesian
economics does not. Te consequences of assuming fexibility or stickiness
determine the explanations and predictions of each model. Te same applies to
many other key features of each paradigm.
Te crisis provoked a strong controversy about the usefulness of each
paradigm in explaining and predicting the crisis. We want to go beyond this con-
troversy and pay attention to the particular features of each theory that explain
why it has failed. We do not focus on the whole theory, but on some specifc
parts that have proven to be defective, or on those parts that, in our view, are
missing. In our research we have realized that in some cases economic theory was
defective because it lacked some parts, namely the functioning of the fnancial
system. It does not matter if the theory is labelled as classical, Keynesian or Aus-
trian. What matters is whether the theory contains an accurate characterization
of the agents and the operational environment or not.
In Chapter 1, we briefy review the fnancial crisis and the forecasts made just
before the crisis by the main international economic organizations such the IMF,
the OECD and the European Union. We stress that these forecasts failed miser-
ably, adding more confusion to the painful scenario we experienced. Many experts
relied on the No one saw it coming hypothesis to avoid being blamed for it. But
they were not right because some authors predicted the crisis. Teir problem is
that the models they were using were too narrow to cope with the scope of the
crisis. So, we propose to broaden the focus to be able to understand the crisis.
In Chapter 2 we explain how to broaden the focus by relying on a theoretical
framework that encompasses the analysis of the characterization of the agents
and the operational environment. We show that we can study neoclassical and
new classical economics, Keynesian, neo-Keynesian and post-Keynesian eco-
nomics and Austrian economics using this approach to ascertain the diferences
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Introduction 3
and similarities among them. As a consequence there is a large set of elements
concerning the characterization of the agents and the operational environment
that can be combined to produce diferent economic paradigms. So, the analysis
has to be carried out from this wider perspective, a kind of meta-theory.
In Chapter 3 we address this point. We stress, following Lakatos, that in every
economic theory there are critical and auxiliary variables. If we remove the critical
variables or assumptions from the theory its nature changes completely. In addi-
tion, we show that if a critical variable proves to be weak or it is falsifed by the
facts, the whole theory is called into question. As a consequence, the process of
theoretical improvement implies the awareness of the criticality of some hypoth-
eses and requires paying close attention to the new facts and data that can switch
successful models into useless ones. As an example, we show in Chapter 4 how real
business cycle theory almost completely displaced the previous models in explain-
ing aggregate fuctuations and became the dominant theory for many years. Te
improvements made in the transmission mechanism of the model reinforced its
usefulness, but the impulse mechanism remained unchanged. As a consequence
this theory has been unable to explain the origin of the fnancial crisis. Conversely,
growth theory has been changing along with changes in available data and includ-
ing more factors to explain why countries grow at diferent rates.
In Chapter 5 we focus on a very meaningful fact of the crisis: policymakers
were faced with a major challenge because the crisis afected nearly all developed
countries and all economic sectors. At the same time they could rely very little on
their macroeconomic and microeconomic toolbox. As a result, they improvised.
In so doing they brought forward a wide array of issues that economic theory
had not analysed and they implicitly established a research agenda for economic
theory over the coming years. Many future improvements in economic theory
will come from these requirements made by policymakers during the crisis.
To analyse how economic theory can improve, in Chapter 6 we focus on the
fnancial system because we have lived through a fnancial crisis. We are certain
that many other issues in economic theory deserve a more in-depth analysis to
be improved, but here we limit our scope to fnancial issues. Te greatest weak-
ness of economic theory in dealing with the fnancial system is that its size and
depth is far larger than the role it plays in economic models. As a consequence,
many territories remain uncharted by economic theory. We engage in a tentative
chartering of these territories by investigating whether the existent economic
paradigms, not only mainstream economics, can enlarge our knowledge about
the fnancial system to avoid future crises. Moreover, we look at the novelties
that need to be incorporated into economic theory to prevent a repeat of his-
tory. While we believe that these novelties will help to avoid future fnancial
crises, they are not enough. We therefore also propose changes in economic the-
ory and in economic policy to avoid similar fnancial crises in the future.
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