The financial meltdown in late 2008, and the prolonged economic downturn it triggered, pose a challenge to mainstream economics. The prevailing economic and financial models did not anticipate the financial crash, nor its consequences for the real economy. Many now believe economic concepts associated with the free-market Chicago school, such as ‘rational expectations’ and ‘efficient markets’, encouraged policy errors such as the deregulation of financial markets, and have now been exposed as inherently flawed. In response to the perceived failure of economic theory, an increasing number have argued economics needs incorporate insights from other disciplines, such as psychology, sociology and history. This thinking has even been embraced by UK Chancellor George Osborne, who claims, ‘These disciplines are enabling us to develop a new approach to policymaking, based on empirical evidence about how people really behave’.

The Institute for New Economic Thinking, funded by billionaire George Soros, was launched in Cambridge earlier this year, with the aim of breaking out of the narrow constraints of mainstream economics. A common theme among the alternative ideas emerging from the economists behind INET and others is the notion that economics cannot be a true science because market activity is driven by irrational human behaviour. This underlying irrationality means the future is inherently uncertain and cannot be predicted. Moreover, no economic model can fully grasp the complexity of irrational behaviour. According to this view, the ‘rational economic man’ of conventional economic theory is unrealistic. The turn to behavioural economics and other psychological theories is lauded by many as a return to a more well-rounded understanding of human nature. As behavioural ideas have become more influential they are now informing economic policy. They provide a new rationale for state intervention in the economy: as the market is propelled by unpredictable behaviours, it will inevitably go awry, and thus the state needs to be prepared to intervene and restore stability. Financial reform measures in the UK, US and elsewhere seeks to encourage responsible behaviour on the part of both financial sector players and consumers, and to regulate and punish ‘bad’ behaviours.

Is it true that the financial meltdown represents a failure of free-market economics? Does behavioural economics offer a better explanation for the financial crisis? Do behavioural and other non-traditional ideas provide a more humanistic perspective on economic activity? Will regulatory reforms of the financial sector based on controlling behaviour lessen the chances of another financial meltdown?

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