During the Depression, Smith's invisible hand functioned in the following way: The mortgage business began in 1932, in response to a liquidity crisis. Back then, a 20 percent down payment was considered the minimum a bank would approve. And for this, the largest investment of their lives, borrowers would travel to their local bank and sit down with a loan officer who probably knew them, whose kids played baseball with theirs.

In those days, the banks owned the loans. If the loan went bad, the banks lost the money. If you knew the man and he fell on hard times, it was difficult to put his wife and kids out on the street on Friday, only to see him in the next pew that Sunday. Faced with that potential embarrassment, bankers were careful to make only those loans borrowers could afford. When customers had problems, the bank was much more likely to work with them to find a solution.

In today's overconnected world, banks externalize the costs of bad loans by creating Collateralized Debt Obligations and passing the losses off to endowments and pension funds. Some shadow entity takes the losses, the banks make a profit on the transactions, and bankers get the added benefit of never having to look the bankrupt person in the eye.

John Maynard Keynes's ideas worked splendidly when the world was less connected. Economic and fiscal policies that stimulated demand created local factory jobs. When those workers spent their paychecks, other jobs were created -- the multiplier effect. Today, stimulus creates more spending but the jobs and the trickle-down are in China.

The mathematically elegant formulas that win Nobel Prizes for modern economists are based on assumptions that no longer apply, and on historical data that is no longer meaningful in our overconnected environment. Unfortunately, those formulas are shaping much of the advice being dispensed. They were right for a less connected world but are wrong now.

Consider Robert Merton, who won the Nobel Prize in economics for his work on the Black-Scholes Model. Merton's model enabled people to assign the appropriate value to exotic financial instruments such as futures contracts and plain vanilla stock options. Merton became a victim of his own invention. He was one of the founders of Long Term Capital Management, which based its derivative trading strategies on the Black-Scholes Model. In 1998, "fat tails" that the model failed to take into account caused the bankruptcy of the firm and nearly triggered an international financial contagion. The slavish devotion to the model persists; it raised its ugly head again during the 2008 financial crisis.

The improper application of the theory is one of the things that fueled the spectacular growth in over-the-counter derivatives, from $60 trillion in 2000 to more than $600 trillion in 2008. This growth took place while the economists and regulators using bricks and mortar logic were arguing that derivatives distributed risk, when in fact massive amounts of derivatives concentrated risk.