'When Economics Works and When it Doesn’t'

Part of an interview of Dani Rodrik:

Q. You give a couple of examples in the book of the way theoretical errors can lead to policy errors. The first example you give concerns the “efficient markets hypothesis”. What role did an overestimation of the scope and explanatory power of that hypothesis play in the run-up to the global financial crisis of 2007-08?

A. If we take as our central model one under which the efficient markets hypothesis is correct—and that’s a model where there are a number of critical assumptions: one is rationality (we rule out behavioural aspects like bandwagons, excessive optimism and so on); second, we rule out externalities and agency problems—there’s a natural tendency in the policy world to liberalise as many markets as possible and to make regulation as light as possible. In the run-up to the financial crisis, if you’d looked at the steady increase in house prices or the growth of the shadow banking system from the perspective of the efficient markets hypothesis, they wouldn’t have bothered you at all. You’d tell a story about how wonderful financial liberalisation and innovation are—so many people, who didn’t have access before to mortgages, were now able to afford houses; here was a supreme example of free markets providing social benefits.

But if you took the same [set of] facts, and applied the kind of models that people who had been looking at sovereign debt crises in emerging markets had been developing—boom and bust cycles, behavioural biases, agency problems, externalities, too-big-to-fail problems—if you applied those tools to the same facts, you’d get a very different kind of story. I wish we’d put greater weight on stories of the second kind rather than the first. We’d have been better off if we’d done so.