Wednesday, July 22, 2009

Failure of microeconomics

Much ink has been spilled and many keys have have been banged on in the blogosphere and elsewhere that the financial crisis in some ways reflects a crisis in macroeconomics and macroeconomic modeling in general. A recap here.

These posts have tangentially also pointed out the failures of regulation (or deregulation) as well as the short term compensation structures that promoted risk taking by the investment bankers. Yet few have attacked the failure of microeconomics. Despite research in principal agent theory and contract theory, economists have failed to put this knowledge into practical use. Likewise the entire premise of pay for performance should be put under closer scrutiny as this represents one of the main reasons for oversized bonuses of investment bankers. All the more reason as advocates of pay for performance have been trying to advance this idea into the field of education and elsewhere.

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