Crisis Compels Economists To Reach for New Paradigm

The pain of the financial crisis has economists striving to understand precisely why it happened and how to prevent a repeat. For that task, John Geanakoplos of Yale University takes inspiration from Shakespeare’s “Merchant of Venice.”

The play’s focus is collateral, with the money lender Shylock demanding a particularly onerous form of recompense if his loan wasn’t repaid: a pound of flesh. Mr. Geanakoplos, too, finds danger lurking in the assets that back loans. For him, the risk is that investors who can borrow too freely against those assets drive their prices far too high, setting up a bust that reverberates through the economy.

For years, his effort to understand this process didn’t draw much interest. Now it does — yet another aftereffect of the brutal deflating of the credit bubble. The crisis exposed the inadequacy of economists’ traditional tool kit, forcing them to revisit questions many had long thought answered, such as how to tame disruptive boom-and-bust cycles.

Mr. Geanakoplos is among a small band of academics offering new thinking about those cycles. A varied group ranging from finance specialists to abstract theorists, they are moving to economic center stage after years on the margins. The goal: Fix the models that encapsulate economists’ understanding of the world and serve as policy-making tools at the world’s biggest central banks. It is a task that could require a thorough overhaul of the way those models work.

“We could be looking at a paradigm shift,” says Frederic Mishkin, a former Federal Reserve governor now at Columbia University.

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