"Time for a Revolution in Economic Thought"

I don't think Anatole Kaletsky is very impressed with the models used by financial economists:

Now is the time for a revolution in economic thought, by Anatole Kaletsky, Commentary, Times Online: ...In this article I will outline some of the unorthodox approaches to economics which conventional economists have ignored and which might have helped to avert the present crisis...

While some economists had warned for years about global trade imbalances, escalating house prices, of excessive consumer borrowing, none of them remotely foresaw the ... total breakdown of financial markets caused by the unforced blunders by investors and banks. Modern economists were inherently incapable of understanding such a problem because they assumed that investors were “rational” and markets “efficient”. These assumptions led inevitably to disaster once they were blown apart. ...

Benoît Mandelbrot,..., who invented fractal geometry and pioneered the mathematical analysis of chaos and complex systems, ... found fruitful applications in the study of earthquakes, weather, galaxies and biological systems from the 1960s onward, but the field that originally inspired his ideas turns out ... to have been finance and economics. Yet 40 years of effort by Mandelbrot to interest economists in the new mathematical methods, which appear to work far better in modelling extreme movements in financial markets than the conventional methods based on statistically “normal” distributions, have been either ridiculed or ignored.

At the other end of the academic spectrum, we find economists treating ideas from sociology, psychology or philosophy with the same derision and disdain. George Soros is no mathematician like Mandelbrot, but he has ... explained convincingly how false beliefs among investors can create self-reinforcing boom-bust cycles of exactly the kind afflicting the world today. But the reaction to these ideas has been the same as to Mandelbrot's:... refusal among ... economists, regulators and central bankers even to think seriously about approaches that challenge the central orthodoxies of ... “efficient” markets inhabited by “rational” investors send price signals which, in some sense, are always right. Reality is very different...

One reason why such fruitful insights have been ignored is the convention adopted by academic economists some 30 years ago that all serious ideas must be expressed in equations, not words. ... But even if we accept the mathematical formalism of modern economics, there is vast scope for new ideas.

A control theory approach, used by serious mathematicians such as Nicos Christofides and Shahid Chaudhri ... has applied advanced mathematics from aerodynamics and control engineering to analyse financial turbulence without the over-simplified assumptions, such as continuous liquidity, which have caused the recent disasters in risk management and regulation.

But the challenge that existing economic orthodoxy may find most disconcerting is Imperfect Knowledge Economics (IKE), the name of a path-breaking recent book by Roman Frydman and Michael Goldberg... Building on ideas of Edmund Phelps, one of the few Nobel Laureate economists who rejected the consensus view on rational expectations, IKE uses similar tools to conventional economics to generate radically different results. It insists that the future is inherently unknowable...

With this obvious, but critically important, change in assumptions, IKE demolishes most of the conclusions of rational expectations. More importantly, it shows that reasonable assumptions about economic uncertainty can produce financial models that ... are statistically far closer to what happens in the real world.

These are just a few examples of the creative thinking that has started again in economics after 20 years of stagnation. But the academic establishment ... will fight hard against new ideas. The outcome of this battle does not just matter to academic economists. Without a better understanding of economics, financial crises will keep recurring and faith in capitalism and free markets will surely erode. ...