Last Monday, I attended the start of a series of lectures about the economic crisis which is organized by Studium Generale. Prof Paul de Grauwe from Leuven started the lecture series. Paul de Grauwe is an interesting economist because he has always combined high quality research with “practical” policy advice and has always been prominent in the public debate. And he was for quite some time member of the Belgian parliament. When I taught a course on International Monetary Integration, Paul used to deliver a lecture on the European Monetary Union and its challenges. He is a great lecturer and a great debater. Both characteristics were demonstrated in his lecture in which he gave a good overview of the issues and the causes of the crisis. One of the interesting points was his focus on the explicit relation between the causes of the crisis and the shift in economic thinking that started in the late 1970s and early 1980s. In particular the changing view on market efficiency was stressed: the increased strong belief in efficient markets implied the belief that mispricing of financial assets cannot occur. This part of the lecture reminded me of the brilliant book by Roger Lowenstein, When Genius failed. This book describes the failure of the LCTM hedge fund, which was led by Nobel prize awarded economists who strongly believed in market efficiency on the financial markets. Their idea was that any deviation from the correct price could only be a very temporary phenomenon and therefore you could benefit from these deviations by betting that the price would return to the correct price. One minor problem was that in order to know the correct price, the risk of the asset must be known.
More economists and commentators support the view that the paradigm shift in economic theory might have caused excessive risk taking on the financial markets. May be it is time for another paradigm shift. Next Monday the Nobel Prize in economics will be awarded. Let us see whether this will signal a paradigm shift. By the way, Pauls’ lecture was a nice upshot of the upcoming lecture by Esther Sent from Nijmegen who will elaborate on the relation between the economic crisis and the crisis in economic thinking.