BUDAPEST – The economic and financial crisis has been a telling moment for the economics profession, for it has put many long-standing ideas to the test. If science is defined by its ability to forecast the future, the failure of much of the economics profession to see the crisis coming should be a cause of great concern.

But there is, in fact, a much greater diversity of ideas within the economics profession than is often realized. This year’s Nobel laureates in economics are two scholars whose life work explored alternative approaches.

Economics has generated a wealth of ideas, many of which argue that markets are not necessarily either efficient or stable, or that the economy, and our society, is not well described by the standard models of competitive equilibrium used by a majority of economists.

Behavioral economics, for example, emphasizes that market participants often act in ways that cannot easily be reconciled with rationality.

Similarly, modern information economics shows that even if markets are competitive, they are almost never efficient when information is imperfect or asymmetric (some people know something that others do not, as in the recent financial debacle) – that is, always.

A long line of research has shown that even using the models of the so-called "rational expectations” school of economics, markets might not behave stably, and that there can be price bubbles.

The crisis has, indeed, provided ample evidence that investors are far from rational; but the flaws in the rational expectations line of reasoning—hidden assumptions such as that all investors have the same information—had been exposed well before the crisis.

Just as the crisis has reinvigorated thinking about the need for regulation, so it has given new impetus to the exploration of alternative strands of thought that would provide better insights into how our complex economic system functions – and perhaps also to the search for policies that might avert a recurrence of the recent calamity.

Fortunately, while some economists were pushing the idea of self-regulating, fully efficient markets that always remain at full employment, other economists and social scientists have been exploring a variety of different approaches.

These include agent-based models that emphasize the diversity of circumstances; network models, which focus on the complex interrelations among firms (such as those that enable bankruptcy cascades); a fresh look at the neglected work of Hyman Minsky on financial crises (which have increased in frequency since deregulation began three decades ago); and innovation models, which attempt to explain the dynamics of growth.

Much of the most exciting work in economics now underway extends the boundary of economics to include work by psychologists, political scientists, and sociologists.
We have much to learn, too, from economic history.

For all the fanfare surrounding financial innovation, this crisis is remarkably similar to past financial crises, except that the complexity of new financial products reduced transparency, aggravating fear about what might happen should there not be a massive public bailout.

Ideas matter, as much or perhaps even more than self-interest. Our regulators and elected officials were politically captured – special interests in the financial markets gained a great deal from rampant deregulation and the failure to adapt the regulatory structure to the new products.

But our regulators and politicians also suffered from intellectual capture. They need a wider and more robust portfolio of ideas to draw upon.

That is why the recent announcement by George Soros at the Central European University in Budapest of the creation of a well-funded Initiative for New Economic Thinking (INET) to help support these is so exciting.

Research grants, symposia, conferences, and a new journal – all will help encourage new ideas and collaborative efforts to flourish.

INET has been given complete freedom – with respect to both content and strategy – and one hopes that it will draw further support from other sources. Its only commitment is to "new economic thinking,” in the broadest sense.

Last month, Soros assembled a remarkable group of economic luminaries, from across the spectrum of the profession –theory to policy, left to right, young and old, establishment and counter-establishment—to discuss the need and prospects for such an initiative, and how it might best proceed.

For the past three decades, one strand within the economics profession was constructing models that assumed that markets worked perfectly. This assumption overshadowed a wide body of research that helped explain why markets often work imperfectly – why, indeed, there are widespread market failures.

The marketplace for ideas also often works in a way that is less than ideal. In a world of human fallibility and imperfect understanding of the complexity of the economy, INET holds out the promise of the pursuit of alternative strands of thought– and thereby at least ameliorating this costly market imperfection.

George Akerlof, a Nobel laureate in economics, is Professor of economics at the University of California, Berkeley.

Joseph E. Stiglitz, University Professor at Columbia University and winner of the 2001 Nobel Memorial Prize, served as Chairman of the Commission on the Measurement of Economic Performance and Social Progress.

Copyright: Project Syndicate, 2009. www.project-syndicate.org