The academic world is often considered to be isolated from the real world. However, now that the world is struggling with an unprecedented financial crisis, one must (at last) pay attention to the role that academic theories may have in the real-world developments.
The very serious problem to be identified is that economists and finance scholars typically have excessive trust in their own theories -- trust that often approaches outright naiveté. This blind trust has tremendous implications to our economic system; at worst it contributes to crises like the one we are experiencing now.
Perhaps the best-known finance theory in the validity of which most academicians blindly believe is the one that states that the financial markets are efficient. This implies that the market values of securities, such as stocks, always reflect all the information that is relevant to their fundamental values.
Based on this theory one often concludes that "markets are always right" in their pricing of securities -- and also rightly price the risks related to the security values.
Now, to the extent that people have without a slightest doubt believed in this "scientific" conclusion, the theory in question has evidently been the underlying primus motor of the current crisis.
Another recent theory in the assumptions of which one trusts beyond reasonable doubt prescribes that firms should disgorge their "free cash flows" to their shareholders. A further theoretical prescription is that firms should disgorge their cash flows by buying back their own shares from the stock market (rather than by just paying dividends).
One blindly believes in these theoretical norms despite the fact that no one has ever been able to unambiguously define "free cash flows". And even less adequately has anyone been able to explain how a firm could -- in case it disgorges away its "free" cash flows -- maintain a reasonable level of investments in development of innovative products. Or, for that matter, a reasonable cash reserve for the rainy day, or September-October.
Also, one blindly believes that a firm should disgorge its cash flows by repurchasing its own shares from the market - even though no real-life evidence whatsoever exists that would prove that such buybacks would maximize the long-term market value of (or payments from) a firm to investors (beyond the short-term push-up to stock price).
Indeed, from the perspective of the financial crisis, it is illustrative to look a bit further into the stock buybacks that the largest US financial institutions made before the culmination of the crisis. (The figures come mostly from a study by William Lazonick of UMass Lowell.)
For instance, Lehman Brothers spent 17 billion dollars on buying back its own shares from the market during 2000-2007, and Bear Stearns 8.4 billion. As late as in 2007, the year preceding their collapses, these banks still spent 2.6 billion and 1.7 billion on stock buybacks, respectively.
And the other financial giants were not worse (or better) than that. In total, Bank of America, Citigroup, Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers, and JP Morgan Chase spent a tremendous 175 billion dollars on stock buybacks in 2000-2007. As late as in 2007, the year before the crisis culminated, the banks still had 28 billion dollars of "free" cash to spend on stock repurchases!
Moreover -- if the absolute figures do not say enough to you -- the figures appear even more insane when you relate them to the firms' net incomes. For instance, the money spent on stock buybacks at Lehman Brothers was about 92 percent of the firm's net after-tax income during 2000-2007. Add to this the dividends that the firm paid (which in themselves were rather moderate) and you can see that the firm disgorged away a sum of money equivalent of over 100 percent of its net income during the years leading to the crisis.
It is really quite obvious that if the banks had left part of these immense amounts of money into their cash reserves, they would have been able to better dampen down the crisis -- or even prevent its culmination altogether.
The cash reserves were disgorged, however, and eventually the stock buybacks only benefited the corporate executives who were early enough to sell their personal stock options in 2007 or before -- with stock prices that had been manipulated temporarily upwards with the very stock repurchases.
There is a multitude of theories similar to "markets are able to price risks rightly" and "using free cash flows on stock buybacks maximizes shareholder value" in the science of finance. (A few others can be found here.) These are theories in the truth value of which the scholars blindly believe, for which they eagerly speak, and which the persuasively teach to students -- but which just aren't very wise in terms of how the real world works.
To end with, perhaps the most tragicomic theory is one that some academic textbooks in the USA have until lately been claiming. It goes: "Securities based on mortgages are in fact risk-free". Right.
All in all, people's trust in the truth value of the "scientific" theories of finance has long ago gone over the top. This blind trust is unquestionably a partial cause to the current crisis.
As a final remark, it must also be noted that the academic theories -- in which way too many people trust -- are at their most hazardous when corporate insiders cunningly exploit that trust. These insiders will always play their cards right so as to maximize their personal income -- while conning the greater fools who trust in the "scientific" theories with even brighter blue eyes. The greater fools are: their own shareowners and investors as well as the politicians, media, and government officials.
Unfortunately, the problem is aggravated by the fact that there are so few academic scholars that would be straightforward enough to stand up and exclaim: "Many of our theories just suck. Big time."