The world is on the brink of another financial crisis if the economic theories shaping today’s financial and public policy are not killed off, John Quiggin, author of "Zombie Economics: How Dead Ideas Still Walk Among Us," told CNBC Friday.
“The dot com crisis really disproved the efficient markets hypothesis once and for all,” Quiggin said.
Long-held beliefs such as that existing share prices always incorporate and reflect all relevant information and that central banks contain the business cycle are flawed, he explained.
“If we look at the presumptions on which regulation has been based, it really is the assumption that asset markets, financial markets, get things right, that their estimates of value are the best possible estimates… we’re seeing the same ideas driving a lot of the discussion with the sovereign debt crisis, that market judgments are the best possible judgments… of the solvency of national governments,” Quiggin told CNBC.
Economists need more realistic models of how people behave, Quiggin said.
“People suddenly realized that European countries can’t pay their debt and there’s this sudden panic of things they haven’t thought of before,” he added.
“I’ve also been very critical of the theory of the great moderation…the idea that the combination of financial deregulation and clever central bank management produced a period of relative calm from the mid-1980s to the global financial crisis,” Quiggin also said.
It is "striking" that not only there are some academics who argue that the crisis was just a blip but that much of the thinking of central banks is that "pretty soon we'll get back to business and put this episode behind us maybe with a bit of tightening," according to Quiggin.
“We need to look back at very successful periods in the 1950s and 1960s when we had largely Keynesian macro policies and tight market regulations…that failed pretty badly in the 1970s…but we need to go back and say what worked in those institutions, and what didn’t work, can we find parts of that institution which can usefully be revived,” he added.
“We now need to redesign regulation in ways that support free markets but at the same time, reflect the fact that…when things go badly wrong, the same people who were calling for manufacturing industry and so forth to feel the sheer wind of competition went to the government to be rescued,” Quiggin said.