Converting the Preachers

"Large swaths of economics are going to have to be rethought on the basis of what's happened." So said Larry Summers, President Obama's chief economic adviser, in an interview in the weeks after the markets crashed a year ago. Yet to a remarkable degree, economic thinking hasn't changed very much at all. (Click here to follow Michael Hirsh).

Now financier George Soros is announcing a $50 million effort to speed things along. This week Soros is gathering some of the leading practitioners of the market-skeptic school, who were marginalized during the era of "free-market fundamentalism," among them Nobelists Joseph Stiglitz, George Akerlof, Michael Spence, and Sir James Mirrlees. He's also creating an "Institute for New Economic Thinking" to make research grants, convene symposiums, and establish a journal, all in an effort to take back the economics profession from the champions of free-market zealotry who have dominated it for decades, and to correct the failures of decades of market deregulation. Soros hopes matching funds will bring the total endowment up to $200 million. "Economics has failed not only to predict and explain what happened but has also failed to protect society," says Robert Johnson, a former managing director at Soros Fund Management, who will direct the new institute. "That's what the crisis revealed. The paradigm has failed. There is no guidance."

It might be tempting to dismiss all this as a war of words among brainiacs. It's not. The critical issues being discussed in Washington about the future regulation and control of the financial industry—the very nature of Wall Street and the health of the economy—depend on this battle of ideas. What led to wholesale deregulation in the '90s and '00s wasn't just Wall Street lobbying money. It was also that key legislators and policymakers, among them Larry Summers, persuaded themselves that deregulation was sound economics and good policy, and that markets and Wall Street institutions could take care of themselves. Many of those views have been discredited by the crisis. But in the absence of a new paradigm of economics, confusion still reigns in Washington. With no new concept of the proper role of government and regulation in the economy, of the proper balance between the markets and their minders, the old school still dominates.

And almost by default, the profession and many of its leading journals remain controlled by free-market thinking out of the University of Chicago, Stanford, MIT, and other institutions, Soros, Johnson, and others argue. Free-market thinking also dominates the debate on everything from the "too big to fail" problem to health care. And some of the economists whose work was most prescient, and most ignored, remain marginalized.

Exhibit No. 1: the late Hyman Minsky, a bushy-haired dissident at the University of California, Berkeley, and Washington University who saw into the heart of financial-market mania perhaps more deeply than anyone else. Minsky's "Financial Instability Hypothesis," which he developed in the '60s, held that success in financial markets always breeds its own instability. The longer a boom lasts, the less market players consider failure a possibility; as a result, careful borrowing, lending, and investment inevitably give way to recklessness and speculative euphoria. Margins and capital cushions come to be seen as unnecessary. At a certain watershed point—sometimes called a "Minsky moment"—the foreordained collapse begins. The most speculative bets crash, loans are called in, asset values plunge, and the downward spiral feeds on itself. That's what happened over the last two years.

Minsky was in effect filling in many of the intellectual blanks left by John Maynard Keynes on the critical question of how financial markets affect the "real" economy. Nonetheless, an assessment of Minsky in 1997, a year after he died, concluded that his "work has not had a major influence in the macroeconomic discussions of the last thirty years." Since the current crash, Minsky has been rediscovered by economic pundits, and now a few economists are struggling to turn his insights into a model of how the economy really works.

But it's all happening very slowly. And with no rules of the road, we have entered a Mad Max world of economics in which even the most eminent of our top regulators and central bankers can't seem to agree on the fundamental nature of financial markets. One clash of titans is occurring between Paul Volcker and Ben Bernanke. Volcker, the former Fed chief, wants commercial banks barred from heavy proprietary trading. "I don't want them to be Goldman Sachs, running a zillion proprietary operations," he told me recently. Bernanke, the current Fed chairman, doesn't want to tamper nearly as much with the structure of the Street; instead, he wants to restrain the big banks through changed incentives, such as by tying compensation to long-term performance, and through increased capital requirements. Across the Atlantic, Mervyn King, the governor of the Bank of England, is engaged in a fierce debate with Britain's chancellor of the Exchequer, Alistair Darling, over breaking up big banks. King says breaking them up is the only way to prevent another catastrophe; Darling says King doesn’t know what he’s talking about.

Even Alan Greenspan appears to be engaged in a fierce argument ... with his own younger self. "U.S. regulators should consider breaking up large financial institutions considered 'too big to fail,' " he said earlier this month. But for most of his life, Greenspan was an Ayn Rand libertarian who abhorred the idea that government should break up anything; he once wrote that "the entire structure of antitrust statutes in this country is a jumble of economic irrationality and ignorance." Bigger was better, he said, and that way of thinking largely governed his stewardship of the Fed from 1987 to 2005. "The control by Standard Oil, at the turn of the century, of more than eighty percent of refining capacity made economic sense and accelerated the growth of the American economy," Greenspan wrote in Capitalism: the Unknown Ideal in 1961. But Greenspan now has this to say about banks: "If they're too big to fail, they're too big. In 1911, we broke up Standard Oil—so what happened? The individual parts became more valuable than the whole. Maybe that's what we need to do."

Maybe it is, or maybe it isn't. Does anybody know anything any more? Again, many of these debates go back to basic questions of economic wisdom. Even Adam Smith, the founder of free-market thinking, noted that banking should be treated differently than other businesses. Financial markets, constantly haunted by panics and manias, are more prone to failure and are more critical to the economy's health. That wisdom was lost or marginalized in recent decades as the "efficient-market hypothesis" ruled the era. But that doesn't mean the pendulum should necessarily swing all the way in the other direction. Should finance be regulated almost like a public utility, as Keynes and Minsky thought? Some, like Bernanke and Summers, say that too much of that kind of thinking will inhibit healthy innovation. "The Keynesians were romantic about the possibilities of governments. The free-marketers were romantic about the possibilities of markets," says Johnson. "But the policies in neither camp have much validity at this point." While this intellectual interregnum drags on, Wall Street-affiliated lobbies are moving into the vacuum and enjoying some success in watering down regulatory proposals, such as those concerning derivatives trading.

One thing seems certain: unless the economists get their act together, at least more than they have, the lobbyists may get to decide what the future looks like.