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Those studying finance economics really felt like they dropped the ball when the financial crisis hit in 2007. They had been so good at helping financial institutions and investors maximize their profits and find new ways to capitalize on assets. They plugged in numbers to predict where the market would go and what would happen. When the housing boom started to slow and home values started dipping slightly, behavioral economics experts thought it was a logical progression for the over-inflated market to bubble and pop. One thing no one saw coming was the crumpling of so many giant financial institutions over just a few months of time.

Nobel prize winning economist Myron Scholes argues that it’s not the models of financial economics that failed us here, but rather, the improper practices of Wall Street and the legislators who allowed them to run too far. Financial firms plugged in data reflecting “a view of the world that was far more benign than it was reasonable to take, emphasizing recent inputs over more historic numbers,” explained Scholes. He said a lot of the models were dead-on and most derivatives and securities performed exactly as predicted, but a few of the exceptions proved disastrous. Since 1998, Scholes had been warning his colleagues about the risk that liquid markets could dry up suddenly and without warning and that individual decisions made in the financial sector could have a great impact on the larger economy as a whole.

One of the criticisms of finance economics and macro economics theories is that it never considers how the inner-workings of financial institutions can impact the larger economy. “That’s the view of microeconomics theorists,” they scoff. In turn, micro-economists are looking at how financial institution decisions affect consumer spending and behavior, rather than scaling up. In 2000, Franklin Allen, president of the American Finance Association, asked the question, “Do financial institutions matter?” He quickly added that most people would be surprised to learn “that institutions play little role in financial theory.” At the time, his assumptions may have been correct, but today the banking system and financial economics are inextricably linked. Even questions as small as “How much should bankers be paid” can affect the loans available to consumers, which in turn affects consumer spending, which in turn can inflate or deflate the American economy.

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