Archive for December 22nd, 2008

This headline is striking for its elegance: “Revise regulation, the theory of market equilibrium is wrong”. Obviously this speaks directly to a major criticism of neoclassical theory by heterodox economists. An article in the Real World Economics Review (formerly PAER) identifies methodological equilibration as one of three axioms intrinsic in neoclassical theory. Soros’ criticism strikes a chord with me.
Now, like any eager economics student, I was first entranced by equilibrium in micro when we drew our supply and demand curves and saw where they crossed- the equilibrium point. I’m naturally attracted to lines that cross at a point. Even better when intermediate macro taught me that in the AS-AD model, the point of intersection was self-reinforcing. Move away from it, and you just go right back; it’s so elegant proving it to yourself.

But, things like the financial crisis throw the notion of equlibrium off kilter:

We are in the midst of the worst financial crisis since the 1930s. The salient feature of the crisis is that it was not caused by some external shock like OPEC raising the price of oil. It was generated by the financial system itself. This fact – a defect inherent in the system – contradicts the generally accepted theory that financial markets tend toward equilibrium and deviations from the equilibrium occur either in a random manner or are caused by some sudden external event to which markets have difficulty in adjusting. The current approach to market regulation has been based on this theory, but the severity and amplitude of the crisis proves convincingly that there is something fundamentally wrong with it.

Even better, Soros explains that when you go away formt he intersection, neat little arrows don’t lead you back:

I have developed an alternative theory which holds that financial markets do not reflect the underlying conditions accurately. They provide a picture that is always biased or distorted in some way or another. More importantly, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect.

I call this two-way circular connection between market prices and the underlying reality “reflexivity.” I contend that financial markets are always reflexive and on occasion they can veer quite far away from the so-called equilibrium. In other words, financial markets are prone to producing bubbles.

What then to do about it? Regulate. This is not the heterodox solution, but no one expects SorosĀ  to call for the nationalization of the financial system, although he oes acknowledge that regulation within the current system is limited by lack of information, another good assumption to start with. It’s encouraging to see another prominent voice approach the financial system with correct premises.

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