What needed to be done in the short term was almost exactly the opposite of what is neededin the long term. First the credit that evaporated had to be replaced by using the only sourcethat has remained credible—namely, the state. That meant increasing the national debt andextending the monetary base. As the economy stabilizes you must then shrink the monetarybase as fast as credit revives—otherwise, deflation will be replaced by the specter of inflation.

We are still in the first phase of this delicate maneuver. The banks are in the processof earning their way out of a hole. To reduce their profitability now would be directlycounterproductive. Regulatory reform has to await the second phase when the moneysupply needs to be brought under control, and it needs to be carefully phased in so as not todisrupt recovery. But we cannot afford to forget about it.

You have seen that my interpretation of financial markets—call it the theory ofreflexivity—is very different from the efficient market hypothesis. Strictly speaking, neithertheory is falsifiable by Poppers standards. I predicted the bursting of the super-bubblein 1998. I was wrong then; am I right now? And some proponents of the efficient markethypothesis are still defending it in the face of all the evidence.Still, there is a widespread feeling that we need a new paradigm and I contend that my theoryprovides a better explanation than the available alternatives. Behavioral economics, which is gainingincreased recognition, deals with only one half of reflexivity—the misinterpretations of reality—butdoes not study the pathways by which mispricing can change the fundamentals.

I realize that my theory of financial markets is still very rudimentary and needs a lotmore development. Obviously I cannot do it on my own. So I may have been premature inputting forward my theory as the new paradigm. But the efficient market hypothesis hascertainly been proved inadequate: has been conclusively disproved. The entire edifice ofglobal financial markets that has been erected on the false premise that markets can be left totheir own devices has to be rebuilt from the ground up.

This concludes today’s lecture, but I also want to make an announcement.

I have decided to sponsor an Institute for New Economic Thinking—INET for short. It will bea major institution fostering research, workshops and curricula that will develop an alternative tothe prevailing paradigm. I have committed $50 million over ten years and I hope other will join.

I also hope reflexivity will be one of the concepts that will be explored, but clearly itshould not be the only concept. I recognize a potential conflict between being a protagonistand a financial sponsor at the same time. To protect against it, I want to erect a Chinese Wallbetween me and the Institute. To this end, I will extend my financial support through theCentral European University and I will not personally participate in INET. The Jury will beexpressly instructed to encourage other alternatives besides the theory of reflexivity.

The plan is to launch INET at a workshop on the lessons of the financial crisis at King’sCollege Cambridge on April 10 and 11, 2010. And I hope that the new economic thinking willfind a home here at the CEU.