The (unfortunate) complexity of the economy

Abstract

The current financial crisis puts the science of economics under huge pressure. Classical economics, which was formalized in the 1950s and the 1960s, is the theory that still shapes much of economic thinking today. Its foundations are the assumptions of economic equilibrium and rational expectations. In theory, deregulated markets should be efficient: prices faithfully reflect the underlying fundamental values, while markets ensure optimal allocation of resources. Any mispricing or forecasting error should be quickly corrected by economic agents, who act with perfect rationality and absolute knowledge about all future states of the world and their probabilities. These equilibrated markets should therefore be stable: crises can only be triggered by exogenous events – such as natural catastrophes, terrorist attacks or political disruptions – and never by the dynamics of the market itself, such as speculation or complex financial engineering. This, however, stands in contrast to most financial crashes, including the latest one, which all seem to be caused by irrational market bubbles.

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