Economists are to blame for the financial/economic crisis

"At the present moment people are unusually expectant of a more fundamental diagnosis; more particularly ready to receive it; eager to try it out, if it should be even plausible. But apart from this contemporary mood, the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual inflluences, are unually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. Not, indeed, immediately, but after a certain interval; for in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil." John Maynard Keynes, The General Theory of Employment, Interest, and Money, 1936.

The current economic/financial crisis was generated by a large array of factors, some of which have received attention in the media and among analysts, but many have not. For example, the economics profession should be credited with having contributed to this (and future?) crises. Why? The economics profession has been dominated by a version of economic theory that diverts attention away from the complex and dynamic nature of economic processes, relationships, and institutions and replaces analysis of that complexity with a form of religious faith in the exchange relationships among human beings and institutions (mostly corporate institutions) as resulting in (to repeat Voltaire's much repeated phrase) the best of all possible worlds. Of course, we summarize these exchange relationships with the term "markets" and we act as if markets are gods. (It may only be luck that there was no theory during American slavery with the same success at shaping the discourse on economic relationships.) It may come as a shock to hear an economist say this, but markets are not magic, nor do markets tell us everything we need to know about economic relationships and their impact on the society. Exchange relationships never tell the whole story nor are these transactions without problems. Indeed, such transactions are no more infallible than the humans (and human operated institutions) that are on either side of the trades we call markets. Lots of these trades are just fine for the parties involved, although that doesn't mean the trade was in the best interest of humanity. Of course, there are always a subset of trades that ultimately make one of the parties quite unhappy, such as results from party A purchasing products or assets that turn out not to be as advertised. And then there's the context of these transactions. Self-employed plumbers do not make trades in the same context as Home Depot, which is likely to be on the opposite side of some of their transactions. (Indeed, the zeal for deregulation has been a game played by large corporate structures and their partners in the governmental structure, to a significant extent, with Joe the Plumber at least as regulated as ever, if not more so, and lacking the resources to deal effectively with the regulation or to forge links with government agents that is so important for large corporations.)

The theoretical framework that came to dominate economics as a profession is called neoclassical economic theory or just neoclassical economics (or sometimes just microeconomics and macroeconomics, although the latter was born as an alternative to neoclassical theory and the former isn't really supposed to be collapsed into a singular theory, although it is certainly taught that way). Neoclassical theory came to dominance in the 1920s and helped to contribute to the Great Depression in the same way the theory is at the root of today's problems. You see, the thinking that neoclassical theory fosters -- the religious belief in magical markets -- was a key driver in deregulating financial institutions and transactions. It is this deregulation that is the trigger for the financial crisis.

The crisis is not the result of subprime mortgages, by the way. Subprime mortgages are simply too small a part of the economy or even the mortgage market to have caused a crisis of this magnitude. The problem is the explosion in derivative instruments linked to mortgages and other forms of debt. Financial institutions discovered that a great deal of money could be made by selling guarantees to cover debt obligations should the firms or households who issued the debt fail to pay up (in other words, default). By now most of us should know how this worked: Agent A guarantees to pay Agent B if Agent C defaults on specific outstanding debt issues (or mortgages). Agent A gets paid by Agent B. Money is made by simply selling a piece of paper that was, and this is a real kicker, insurance. Why kicker? Because the transaction was not treated/regulated as insurance. If it was treated as insurance, the regulators could have required that the firms issuing the insurance have sufficient capital to support the tons of paper they were selling (which would have slowed down the build-up of paper and made a crisis less likely). Was this regulatory oversight? No, it was the direct result of continual arguments against regulation by referencing neoclassical axioms about markets getting it right and producing that best of all possible worlds. It was not that the parties involved did not know this was insurance, including the Alfred E. Newman-like government agents who decided to allow these transactions to be treated as something other than insurance and not worthy of regulation. Instead, since the early 1980s the U.S. government has been hijacked by neoclassical mythologies about markets -- which have also been moving, virus-like, throughout the globe. In other words, theory is consequential and is one of the factors shaping the world.

Another trend in economics is also complicit. Given that the neoclassical framework is really a religion and has short-circuited the ability of young economists to ask certain types of questions -- such as whether or not there are better ways to organize economic activities than the growth of the public corporation controlled by a largely autonomous bureaucratic elite statutorily required to behave (collectively) like a superorganic sociopath (no, I'm not being harsh, look up the definition of sociopath and then test it against the motivation and actions of most large corporate bodies, especially those where the boards and management are fulfiling their fiduciary responsibilities). Economists simply do not challenge the status quo but have become engineers of that status quo (trying to find ways to improve the existing edifice without ever being a threat to it). Well, perhaps engineers is not the right word. Many economists have become nothing more (or less) than applied statisticians (although statisticians who are mostly incapable of generating their own data sets). Indeed, one really doesn't even need to know much economics to be an economist. Freakonomics, rather than economics, is increasingly the field of study for newly minted Ph.D. economists.

But fortunately, when there is a crisis, economics becomes more popular among economists (at least that subset of economists who know a little economics -- actually had a course or two that delved into the history of economic thought or offered alternative macro or microeconomic theories to contrast with the neoclassical orthodoxy). And so President-elect Obama and his team of economists have rediscovered Keynesian economic theory (or that part of Keynesian/Wicksellian theory that postulated the need for government action to intervene to stop a deflationary crisis). The market-god has been shelved for the time being. It will be replaced with a Keynesian strategy of planning and implementing an expansion in aggregate demand, as well as Keynes favored policy of targeting the spending to activities (such as infrastructure) with long term positive impacts on a society's abilty to generate wealth. After Keynesian policies fix the problem, don't be surprised if the high priests of neoclassical economics reassert authority over the field, arguing that the crisis really wasn't the result of "the free market" but of the very government intervention that saved their hides.