In the last days of 2009, I mentioned that the economic theory is going through hard times. This is particularly the case for macroeconomic theory which tries to explain how variables like national income, unemployment rate, interest rate, exchange rate or price level are determined at a certain point in time and how do these move in time and whether or not these movements can be altered via economic policy interventions of the state.

In 1970s, economic theory, which argued that the economy may not reach 'equilibrium' alone and in periods where unemployment rises, particularly, this rise should be fought, was generally accepted. This theory was introduced by Keynes and developed by his followers. This school known as Keynesian school recommended active economic policies for they thought that confidence to the economy played a major role in people's decisions. This confidence could have been affected by rumors around, or feelings of people to try not to hurt others. For instance, excessive optimism based on rumors could have led to a rapid rise in demand for bonds and thus a price bubble. This theory was bombarded with criticisms particularly in 1970s and gradually lost ground. This bombardment to a certain extent stemmed from understandable concerns; Keynesian models made 'arbitrary' assumptions about the behavior patterns of economic units.

Models developed in response to Keynesian models however, gave harm to economic theory as much as they made significant contributions. The view that markets would operate efficiently and thus reach equilibrium when they were left alone in the absence of any intervention gained ground. These models clearly 'proved' (under certain assumptions) that economic policy interventions by the state were not necessary.

Interestingly, the biggest harm of this 'neo-classical' theorem completely opposed to Keynesian theorem was on the regulation and supervision of financial markets. The interesting point was that financial markets are those where individuals who are more informed and equipped than others operate. In this sense, assumptions of the neoclassical school are more valid in financial markets. Innovations in this market were note regulated and supervised in the context of the views of this school to a large extent. On the other hand, crises which pushed economies into trouble emerged to a large extent from the lack of supervision and regulation in financial markets.

In his testimony in US Congress on October 23, 2008, Former President of FED Greenspan says: "We are in the midst of a once-in-a-century credit tsunami. Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief." This translates as follows: economic units (financial institutions) acted in line with their interest. In that case, markets operate efficiently when left alone. Therefore, there is no 'much' of a need for market regulations and supervisions. On the other hand, as the economies were pushed in recession and unemployment rose, developed countries clutched at old-fashion Keynesian policies. In this sense, views of the neoclassical school were not harmful. For instance, even the Bush administration who believed that the market was almighty introduced (had to introduce) measures to increase public expenditures in the last global crisis.

One of the challenges of the science of economics is that it is based on human behaviors. Future expectations of individuals affect their present decisions. As a result, economic developments are shaped by these expectations. The desire to make economics 'much of a science' turns into the desire to construct mathematical and statistical models based on these expectations. However, these expectations can also be related with psychology as Keynes insistently suggests. This is exactly where the challenge comes to the surface. If you assume, as Greenspan talks, that people act in line with their interests all the time, mathematical modeling gets 'easier'. But this time, you might diverge from the 'reality'. There is no doubt that each challenge attracts and triggers the struggle. Recently, new studies aiming to correct the weaknesses of macroeconomic theory appear. I will continue with this on Sunday.

This commentary was published in Radikal daily on 10.01.2010