The assumptions that financial markets provide perfect prices and that people are perfectly rational were the same assumptions made by the Classical Economists before the Great Depression. It became the new assumption when Keynesian explanations of Depressions being caused by a lack of adequate demand were rejected in a flurry of new mathematical models and a flash of computer monitors. Unfortunately the models were essentially based on what Krugman calls ketchup economics.
Ketchup economics means the "...because a two-quart bottle of ketchup costs twice as much as a one-quart bottle, finance theorists declare that the price of ketchup must be right." It ignores the underlying factors that establish the true value. So if you compare home prices at a given point of time and the price of two comparable homes is roughly the same, then the price is right. There is no consideration of whether the income of the homeowners can support the mortgage required to meet that price. Those fancy mathematical models threw out answers that just don't match up with reality in the long run.
Financial markets, unfortunately, are well known to be based on short term considerations and to not consider long term factors.
The economic and financial experiences world wide of the last two years has left economies world wide in much worse shape than previously and also it has left the profession of Macroeconomics strongly questioning where they went wrong. Bankers are beginning to speak publicly about the need to put human beings back into the lending decisions and not depend on the mathematical models.
Paul Krugman has presented a fascinating overview of the questions the Macroeconomic profession are now grappling with The generally accepted new assumption goes back to Keynes' conclusion that recessions, even the depression, are caused by lack of adequate demand. But the beauty of the neo-classical models holds a powerful attraction. The recognition of what went wrong is not yet there.
Go read Krugman's article. It is lengthy, but written in language a layman with some understanding of Macroeconomics can handle.
OK. I want to quote Krugman on why the government has to be spending so much right now.
During a normal recession, the Fed responds by buying Treasury bills — short-term government debt — from banks. This drives interest rates on government debt down; investors seeking a higher rate of return move into other assets, driving other interest rates down as well; and normally these lower interest rates eventually lead to an economic bounceback. The Fed dealt with the recession that began in 1990 by driving short-term interest rates from 9 percent down to 3 percent. It dealt with the recession that began in 2001 by driving rates from 6.5 percent to 1 percent. And it tried to deal with the current recession by driving rates down from 5.25 percent to zero.This observation was at the core of Krugman's book "Depression Economics." It also explains why attempting to balance the federal budget anytime soon is likely to cause a second economic downturn.
But zero, it turned out, isn’t low enough to end this recession. And the Fed can’t push rates below zero, since at near-zero rates investors simply hoard cash rather than lending it out. So by late 2008, with interest rates basically at what macroeconomists call the “zero lower bound” even as the recession continued to deepen, conventional monetary policy had lost all traction.
Now what? This is the second time America has been up against the zero lower bound, the previous occasion being the Great Depression. And it was precisely the observation that there’s a lower bound to interest rates that led Keynes to advocate higher government spending: when monetary policy is ineffective and the private sector can’t be persuaded to spend more, the public sector must take its place in supporting the economy. Fiscal stimulus is the Keynesian answer to the kind of depression-type economic situation we’re currently in.
At the end of his article Krugman lays out where he thinks the profession has to go next, with his reasons for thinking so. anyone interested in macroeconomics or in investing needs to read this article carefully.