To be more specific, a subset of mainstream economics is in the dock. This subset, microeconomics, studies economic actions of individuals and firms in a market. The financial crisis, as should be obvious, is at one level an outcome of individual/firm market actions. There’s a macroeconomics (study of economic variables in the aggregate; government spending, total private investment, central bank policy) aspect to the crisis, too. Questions like whether interest rates were too low or whether government policy helped misallocate credit are among the macroeconomic debates going on. But post-crisis, mainstream macroeconomics is not being charged with having a theoretical framework that’s “fundamentally useless”.

That description came recently from James Galbraith, well-known economist son of the hugely more famous John Kenneth Galbraith. Galbraith Jr was speaking for many who have a deep suspicion of microeconomics that, roughly put, loves market and math.

Most economists will dismiss his statement as being as wrong as it is strong. But that would be a sub-optimal strategy. True, the framework is not useless. It is extremely powerful, in fact. But these economists owe a few explanations.

Of the many questions being asked by serious people who aim to improve mainstream economics, two are critical. One question is on market, the other on math.

The Market Question. Everyone who has read something on the financial crisis knows that at the heart of it was widely distributed risk that came from widely distributed financial assets that were created — engineered — from simpler financial assets. Mainstream economics has provided brilliant theoretical proofs that distributing risks is a smart thing in a market.

The basic idea is that different people have different risk tolerances. Therefore, if some financial assets (say, bank loans) can be bundled and bits of it sold to buyers with varying appetite for risk, it will free the primary lender (the bank) from the obligation of carrying all the risk. So risk will be borne more efficiently and the bank’s ability to lend will increase.

Don’t sneer at this just because jokes about investment bankers outnumber jokes about lawyers today. Distributing risks is at the heart of such plain vanilla financial products like insurance or company shares. Issuing shares allows a company’s business risk to be spread widely between shareholders.

But this distributed risk idea works really well for markets if all market participants have equal access to all relevant information. Remove that assumption and there’s a problem.

When risk is distributed widely, as it was when assets of various kinds were bundled and bits sold to many financial firms, ideally everyone involved should have known if, say, particularly risky loans were bundled with relatively safe assets. But one of the things that happened in the financial crisis was that sellers of risky mortgages had better information than buyers of bundled assets. There was information asymmetry.

So when risky assets turned bad, holders of bundled assets, who didn’t have all the information, acted on the basis that the whole thing was risky. Since there were many buyers of these bundles — risk was widely distributed — the market for efficiently managing risk ended up increasing market participants’ perception of risk. Basically, the model failed.

In the real world, credit rating agencies were supposed to address part of the information asymmetry. As is well known, they failed. Post-crisis, there have been calls for better rating and better disclosure on bundling. But these are pragmatic solutions. Economists have to address the theory.

Now, it’s not as if economics hasn’t dealt with information asymmetries. Extraordinarily insightful work has been done on this. Nobel Prizes have been awarded for work on information asymmetry. But what theoretical economics is unable to answer for now is whether the conflict between information asymmetry and risk distribution via asset bundling is solvable.

The Math Question. This centres on modelling returns on investment. The mainstream theory elegantly proves that diversified portfolios give the best bang per buck. Financial traders routinely use the tools of this theory. And mostly it does seem to work; everyone is not losing money all the time. But, like in the previous case, there’s a key assumption: returns to investment have to be normally distributed; there should be no extremes.

If a statistician says the average IQ of Indian Express staffers is x with a small standard deviation of y and that this is a normal distribution, what he means is that a big majority of Express staffers will have their IQ in the x-y and x+y range. There will be a very few on either side of this range.

But investment returns in finance may not always be normally distributed; there may not be a meaningful average or a meaningful small deviation from it. In jargon, this is called power law distribution. Such distribution of investment returns can happen, especially at a time of quick change, in technology, in globalised investment opportunities, in financial sophistication, etc.

There’s no standard set of theoretical tools, as there’s for theory based on normally distributed returns, that can apply to power law distributions. Again, it’s not as if theory doesn’t recognise the issue. But it’s work in slow progress that has been shown up to be inadequate by the crisis. When years of good returns based on standard theory of investing can be destroyed by one extreme event, when, moreover, the theory predicts that the extreme event is extremely unlikely (thanks to the small standard deviation assumption), the theory clearly needs a revision.

Will mainstream economics respond to these challenges? Some critics argue the intellectual-cultural inertia of mainstream economics, which is in a powerful position in all influential centres of learning, is too strong and therefore disincentivises the big intellectual investment required.

But note that this investment is risk-free, because there’s no dishonour in trying and failing. And it also promises very high returns; greatness is assured upon success. You would expect economists to respond to that kind of an incentive.

saubhik.chakrabarti@expressindia.com