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Different Approaches to the Financial Crisis
Sheila C Dow
SCEME and Division of Economics, University of Stirling, Scotland

Abstract
The economic crisis has exposed shortcomings in standard economic theory and provided an impetus for new economic
thinking. But the theoretical debate in the wake of the crisis has been unduly constrained by the terms of the mainstream
approach to economictheory. Like any approach, it is characterised by a way of framing reality, giving meaning to terms
and setting criteria for good argument. It also determines how any economic theory is understood, whether from the
history of economic thought or from the contemporary literature. But there are other approaches to economics which
would open up the field to a much wider range of possibilities fornew economic thinking. Addressing the challenge that
any reader bases her understanding on her own approach, the purpose of this paper is to attempt to explain what it
means to consider different approaches and why it matters for policy. This is done by discussing two features of the
financial crisis which pose particular problems for economic theory. These are the role of changing marketsentiment in
driving asset prices on the one hand and the breakdown of trust relationships in banking on the other (the moral hazard
issue). We will see how these are addressed by mainstream theory and by alternative approaches. First, market
sentiment is discussed within the mainstream rational-optimising framework, where risk is quantifiable, and compared
with the Keynesian approach based on thegeneral uncertainty of knowledge, where reason, evidence and sentiment are
integrated. The moral hazard issue is then discussed in its mainstream form in terms of rational opportunism and in its
institutionalist form in terms of the foundation of social relations (including relations between institutions) in trust. It is
shown that different ways of approaching theorising in each case implydifferent policy measures. It is argued further that
an exclusively deductive mathematical approach to analysis of market sentiment and trust is unduly limiting and that a
more pluralist approach would more fully address the issues.

Keywords: methodological approach; market sentiment; trust; banking

Introduction
The financial crisis which began in 2007 has sparked an unusual degree ofreflection on the state of
economics. For many economists, it was challenging to explain the crisis. Mainstream theory had been
founded on the presumption of underlying stabilising tendencies in competitive markets. But the authorities
were required to act without waiting until the dust had settled in academic economics. In the process
reference was made to theories outside the mainstream whichaddressed problems arising from markets not
equilibrating at the full employment level and to figures from the history of economic thought. Thus Keynes
was invoked in support of expansionary fiscal policy, while Minsky’s theory of financial instability was invoked
in support of the supply of liquidity to the financial system. Reference was also made to other older literatures
for alternativeexplanations of the crisis, notably the Hayekian literature which focused on interest rates
having been held below the natural rate.
Now a range of explanations for the crisis has been developed within the mainstream which retains
the foundation of a presumption of equilibrating competitive markets. These explanations refer to factors
which inhibited this equilibrating process, particularlyinformation asymmetries, irrational behaviour and state

Economic Thought 1:80-93, 2012

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interference in the form of the lender-of-last-resort facility. The policy solutions follow directly in the form of
removing these factors to prevent a recurrence of crisis – that is, making reality more like the standard model.
The policy of fiscal expansion has generally been reversed, the focus...