Economists are learning from the financial crisis, but investors should not relax. The gaps in the profession’s knowledge were well explained in the International Monetary Fund’s harsh assessment of its own intellectual shortcomings before 2007. The list is daunting: excessive trust in both financial markets and the new techniques of financial risk-spreading, an inadequate understanding of how finance influences the real economy, and an over-reliance on models “as the only valid tool to analyse economic circumstances that are too complex for modelling”.
Some things have changed. There is less faith in financial markets and more attention to monetary factors. For example, when pre-crisis economists talked about the commodity boom, they almost never mentioned easy money. But last week’s economic summary from the miner Rio Tinto gave finance – “low interest rates, quantitative easing and sovereign debt concerns in OECD economies” – equal billing with supply and demand.
The greatest challenge for all economists is to understand the dynamics of the financial-economic nexus. It is a tough slog. Macro-economists predict growth and unemployment rates with models that do not include financial variables. Prevailing financial models famously underestimated the chance of extreme events.