Phelps on economic opposites - Keynesian and neoclassical

Edmund Phelps is a outstanding economist and has contributed to the expectations theories. His analysis of intertemporal tradeoffs in macroeconomic policy is the prime reason for his Nobel Prize in economics.

He has a comments on what he calls the economic opposites: Keynesian economics and the neoclassical equilibrium theory.

He says: "In the theory wars, which are as much wars over policy choices, two very bad kinds of theories are driving out good theories."

One very interesting point Phelps makes is about the cause of the great financial crisis:

"The most profound fallacy is the newfangled idea that misalignment of incentives in banks caused the housing bubble – a bubble that, when it burst, shook the economy to its foundations. All can agree that increased lending and building ran into the awkward fact that costs increase when production is stepped up. On that account, prices sought a higher level. But that analysis does not capture the steep four-year climb in housing prices, which rose by more than 60 per cent.
To account for so large an increase, we have to recognise that expectations played a role. Speculators appear to have expected that housing prices would go sky-high, so prices took off and then went on climbing in anticipation that those high prices were getting closer. The banks, seeing the houses offered as collateral were worth more and more, responded by supplying an increasing flow of mortgage loans.
From this viewpoint, speculation drove the crisis. Misaligned incentives were not sufficient to do it – and not necessary either. Bubbles long predate bonuses. The crisis could have happened with a 1950s financial sector. The lesson the crisis teaches, though it is not yet grasped, is that there is no magic in the market: the expectations underlying asset prices cannot be “rational” relative to some known and agreed model since there is no such model."

See Edmund Phelps "A fruitless clash of economic opposites", 2/11/2009, http://www.ft.com/cms/s/0/f71cfc6a-c7e6-11de-8ba8-00144feab49a.html