PensionReforms summary and comments
There seems to have been something more to the global economic crisis than the past experiences of 'boom and bust'.  We have certainly experienced the boom and the bust in the last 2-3 years but the pain seems to have been magnified by other influences.  The 'protection' promised by new forms of investment and financial products and also by geographic spread didn't materialise.

This report is the outcome of "one week of intense discussions within the working group on 'Modeling of Financial Markets' at the 98th Dahlem Workshop, 2008" (and is therefore dubbed the "Dahlem report").  It suggests that the relatively recent innovations in financial services and the greater inter-connectedness of global financial markets both probably contributed to the development of the boom and the bust.

"Both aspects have been largely ignored by academic economics.  Research on the origin of instabilities, overinvestment and subsequent slumps has been considered as an exotic side track from the academic research agenda (and the curriculum of most economics programs).  This, of course, was because it was incompatible with the premise of the rational representative agent. This paradigm also made economics blind with respect to the role of interactions and connections between actors (such as the changes in the network structure of the financial industry brought about by deregulation and introduction of new structured products). Indeed, much of the work on contagion and herding behavior .... which is closely connected to the network structure of the economy has not been incorporated into macroeconomic analysis."

The report suggests that the discipline of economics hasn't done the job it should have done:

"We believe that economics has been trapped in a sub-optimal equilibrium in which much of its research efforts are not directed towards the most prevalent needs of society.  Paradoxically self-reinforcing feedback effects within the profession may have led to the dominance of a paradigm that has no solid methodological basis and whose empirical performance is, to say the least, modest."

The report says that economic modelling seems to have been used by policymakers, rating agencies and the finance industry itself without a clear understanding of its limitations or the significance of their assumptions and the interaction between those.

"[The economics profession] has failed in its duty to society to provide as much insight as possible into the workings of the economy and in providing warnings about the tools it created.  It has also been reluctant to emphasize the limitations of its analysis.  We believe that the failure to even envisage the current problems of the worldwide financial system and the inability of standard macro and finance models to provide any insight into ongoing events make a strong case for a major reorientation in these areas and a reconsideration of their basic premises."

Models tend to assume that markets are inherently stable and tend not to take into account 'soft' things like the way individuals and institutions respond to changing conditions.  This means that not all actors behave rationally all the time and neither will all actors in the economy react similarly.  Why, for example, did not more people respond to what seemed, even at the time, to be a housing bubble in the US or the rising tide of sub-prime mortgages and the allegedly 'secure' derivatives that were built on those?

In this case, having an expanding variety of financial products did not reduce risk across the system but now seems to have magnified it.  The report suggests that was caused, at least in part, by the failure of models to price these new securities accurately.  And that seemingly led to more people doing the same type of thing.

Rating agencies were subject to similar pressures for similar reasons.  It turns out that they also seemed not to understand the real nature of the securities they were reviewing.

Because most economic models do not accommodate a crisis of the kind the world has endured:
"In our hour of greatest need, societies around the world are left to grope in the dark without a theory. That, to us, is a systemic failure of the economics profession."

The report suggests that economists "...as with all scientists, have an ethical responsibility to communicate the limitations of their models and the potential misuses of their research. Currently, there is no ethical code for professional economic scientists. There should be one."

PensionReforms suggests that, while economic models may have had a role to play in the global economic crisis (by not 'noticing' the weaknesses), there were some obvious other candidates.  Investors and governments have re-learned the perils of leverage - it can turn a good return into a great one and a bad return into a disaster.  Perhaps trustees also need to remember what 'fiduciary responsibility' actually means and to understand what happens when markets change so much that values are difficult to establish or realise, especially when even 'markets' seem not to know.  On that, perhaps accounting standards need to step back from 'hard and fast' valuation rules.  Governments also need a better understanding of their appropriate role - not as a participant in financial markets (other than in the last resort) but as regulator.  Tax systems also have a role to play - when one part of financial markets has a more favoured tax treatment than others, investors are less sensitive to poor returns or high costs.

However, it does seem to PensionReforms that economic models should be tested against the real world to establish their credibility.  As the report notes:
"In summary, it seems to us that much of contemporary empirical work in macroeconomics and finance is driven by the pre-analytic belief in the validity of a certain model.  Rather than (mis)using statistics as a means to illustrate these beliefs, the goal should be to put theoretical models to scientific test (as the naïve believer in positive science would expect)."

The report recommends "a more data-driven methodology".  It seems difficult to disagree.  (File size 401 KB; 19 pp)  314