Epistemology and the Financial Crisis

Abstract

Reputable contemporary economic theory assumes that agents are endowed with a fully predetermined model that is baked into the foundation of the world, existing before people come to carry out its destiny. In this narrative, agents are either rational or, if they cannot correctly perform the calculations to optimize their preferences, they must be irrational. In the grip of this analytical vise, the neoclassical model permits two explanations for the financial crisis: poor incentives or the mania of crowds. Neither of these explanations holds up in light of the evidence. But if we accept that bankers, investors, regulators, and ratings agencies lacked a fully predetermined model, we can arrive at a more nuanced understanding of how financial institutions ended up in such bedlam, why credit markets collapsed, and why they took so long to recover.