The British economist Willem Buiter has a nerdy but important post that makes for heavy reading, but answers the title question, in "The unfortunate uselessness of most ’state of the art’ academic monetary economics". He asserts that what is being taught in universities is irrelevant to today's crisis:
Most mainstream macroeconomic theoretical innovations since the 1970s . . . have turned out to be self-referential, inward-looking distractions at best. Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes rather than by a powerful desire to understand how the economy works - let alone how the economy works during times of stress and financial instability. So the economics profession was caught unprepared when the crisis struck (bold emphasis added).
Both the New Classical and New Keynesian complete markets macroeconomic theories not only did not allow questions about insolvency and illiquidity to be answered. They did not allow such questions to be asked.
The essay concludes:
I believe that the Bank (of England) has by now shed the conventional wisdom of the typical macroeconomics training of the past few decades. In its place is an intellectual potpourri of factoids, partial theories, empirical regulaties without firm theoretical foundations, hunches, intuitions and half-developed insights. It is not much, but knowing that you know nothing is the beginning of wisdom.
So the quick and easy answer is that governments relied on academic economists, who were unprepared for a replay of the collapse of markets and trade due to a similar debt deflation last seen in the Great Depression; and all the conventional policies have been tried and are failing.
Therefore the fundamental overvaluation of asset class after asset class, such as securitized loans and stocks, is unveiled, and market after market is collapsing in a manner not seen since the 1930s.
John Maynard Keynes was a revolutionary in the 1930s. Relying on a bastardized misinterpretation of some of his theories three generations later to fix our current problems, after these theories have become mainstream and then some, is similar to the reliance on the then-conventional wisdom of balanced budgets and protection of domestic industries followed by Herbert Hoover.
As this post is written, Asian stock markets have reversed to the upside, but for the wrong reason: "Most Asian Stocks Advance Amid Government Policy Speculation" (Bloomberg.com), the speculation of course being that governments will spend and borrow more.
Free markets will work again, and work well, if governments would let legitimate supply and demand forces work. Governments have enough to do to rationalize the debt mess in a fair and practical way and to prevent banksters from ever again building a rickety structure that these banksters can collapse upon our heads, or at least credibly threaten to do so, unless they are paid off in good times or bad.
That would be change we can believe in.
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