Is It Time For A New Economic Model?

The financial crash of 2008 highlighted weaknesses in traditional economic models. It also underlined the need for new thinking and a new approach to understand how the economy works.

Financial crash

Economists were exposed by the worldwide crash and have struggled to recover in the intervening decade. Their hallowed models were hollowed out overnight, as economies around the world suffered a collapse rarely witnessed. The discipline of economics went from a reliable science with long and established foundations to little more than collection of random opinions. Decades of unassailable theories were thrashed by the unexpected crash that left governments scrambling for explanations in the chaos that followed.

Lessons have been learned but significant problems remain, not least the need to reflect on what happened and why. Some economists have changed their approach even though the habit of using the same models persists among many. There is already a tendency to cling to traditional thinking rather than seek a better understanding of what works.

The task today is to unbundle the models relied upon for far too long. The fear of course is the need to begin again, as it undermines engrained beliefs not least in how the subject is taught in the sheltered spaces of academia. The task is enormous and even at this early stage there are signs it may be too big an endeavour for many minds in the field.

Basic flaws

Economic thinking began by trying to understand how economies actually work before it switched to study what economists thought was happening to people and firms. The basic flaws in the new approach lay in the assumption that models accurately reflect the day-to-day workings of the market. The models proved to contain imperfections, which were overlooked even in the run up to the crash that destroyed the lives of millions of people.

The biggest assumption was that people act rationally on the basis of complete information, which is at odds with normal human behaviour. Economic models do not reflect how people act or how the world works because they cannot. This belief however formed the basis of much economic theory for more than a hundred years. The real challenge lies in developing a theory that links cause and effect, as is the case in science based subjects. Economic performance of course doesn’t follow predictable patterns because its actors are individuals and individual companies that by their nature operate outside the realm of reason.

Once it became apparent that economic models did not reflect reality they were tweaked by adding assumptions to explain what went wrong. Events that didn’t fit were treated as exceptional, even though they became the norm and beyond the accommodation of any credible model. There is now however a growing realisation that economic models need significant revision if not completely scrapped as their failings can no longer be hidden or ignored.

So, there is mounting evidence that traditional economic models are broken, as new thinking is needed to understand what happens in the real world.