Thursday, November 27, 2014

Why Did Economists Not Foresee the Crisis?

CHICAGO – At the height of the financial crisis, the Queen of England asked my friends at the London School of Economics a simple question, but one for which there is no easy answer: Why did academic economists fail to foresee the crisis?

Several responses to that query exist. One is that economists lacked models that could account for the behavior that led to the crisis. Another is that economists were blinkered by an ideology according to which a free and unfettered market could do no wrong. Finally, an answer that is gaining ground is that the system bribed economists to stay silent.

In my view, the truth lies elsewhere.

It is not true that we academics did not have useful models to explain what happened. If you believe that the crisis was caused by a shortage of liquidity, we had plenty of models analyzing liquidity shortages and their effects on financial institutions. If you believe that the blame lies with greedy bankers and unthinking investors, lulled by the promise of a government bailout, or with a market driven crazy by irrational exuberance, we had studied all this too, in great detail.

Economists even analyzed the political economy of regulation and deregulation, so we could have understood why some US politicians pushed the private sector into financing affordable housing, while others deregulated private finance. Yet, somehow, we did not bring all this understanding to bear and collectively shout our warnings.

Perhaps the reason was ideology: we were too wedded to the idea that markets are efficient, market participants are rational, and high prices are justified by economic fundamentals. But some of this criticism of “market fundamentalism” reflects a misunderstanding. The dominant “efficient markets theory” says only that markets reflect what is publicly known, and that it is hard to make money off markets consistently – something verified by the hit that most investor portfolios took in the crisis. The theory does not say that markets cannot plummet if the news is bad, or if investors become risk-averse.

Critics argue that the fundamentals were deteriorating in plain sight, and that the market (and economists) ignored it. But hindsight distorts analysis. We cannot point to a lonely Cassandra like Robert Shiller of Yale University, who regularly argued that house prices were unsustainable, as proof that the truth was ignored. There are always naysayers, and they are often wrong. There were many more economists who believed that house prices, though high, were unlikely to fall across the board.

Of course, these expectations could have been distorted by ideology – it is hard to get into the past minds of economists. But there is a better reason to be skeptical of explanations relying on ideology. As a group, neither behavioral economists, who think that market efficiency is a joke, nor progressive economists, who distrust free markets, predicted the crisis.

Could it be corruption? Some academic economists consult for banks or rating agencies, give speeches to investor conferences, serve as expert witnesses, and carry out sponsored research. It would be natural to suspect us of bias. The bias could be implicit: our worldview is shaped by what our friends in industry believe. Or it may be an explicit bias: an economist might write a report that is influenced by what a sponsor wants to hear, or give testimony that is purely mercenary.

There are enough instances of possible bias that the issue cannot be ignored. One remedy would be to ban all interaction between economists and the corporate world. But if economists were confined to the ivory tower, we might be unbiased, but we would also be ignorant of practicalities – and thus even less capable of predicting problems. One way to restore trust may be disclosure – for economists to declare a monetary interest in a particular analysis and, more generally, to explain who pays us. A number of universities are moving in this direction.

But I believe that corruption is not the main reason that the profession missed the crisis. Most economists have very little interaction with the corporate world, and these “unbiased” economists were no better at forecasting the crisis.

I would argue that three factors largely explain our collective failure: specialization, the difficulty of forecasting, and the disengagement of much of the profession from the real world.

Like medicine, economics has become highly compartmentalized – macroeconomists typically do not pay attention to what financial economists or real-estate economists study, and vice versa. Yet, to see the crisis coming would have required someone who knew about each of these areas – just as it takes a good general practitioner to recognize an exotic disease. Because the profession rewards only careful, well-supported, but necessarily narrow analysis, few economists try to span sub-fields.

Even if they did, they would shy away from forecasting. The main advantage that academic economists have over professional forecasters may be their greater awareness of established relationships between factors. What is hardest to forecast, though, are turning points – when the old relationships break down. While there may be some factors that signal turning points – a run-up in short-term leverage and asset prices, for example, often presages a bust – they are not infallible predictors of trouble to come.

The meager professional rewards for breadth, coupled with the inaccuracy and reputational risk associated with forecasting, leads to disengagement for most academics. And it may well be that academic economists have little to say about short-term economic movements, so that forecasting, with all its errors, is best left to professional forecasters.

The danger is that disengagement from short-term developments leads academic economists to ignore medium-term trends that they can address. If so, the true reason why academics missed the crisis could be far more mundane than inadequate models, ideological blindness, or corruption, and thus far more worrisome; many simply were not paying attention!

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    1. CommentedKuruvilla Abraham

      In response to it is argued that stock markets are modeled, in accordance with the Kelly criteria, as a game of repeated trials. Which in simple terms means that a young child has to repeatedly fall to learn what the safety limits of a garden swing are? Be that as it may, the young child is confident that the physical limits once learned cannot be easily tampered with. He or she and the nannies (market regulators) know in advance what the limits and restrictions are. The same cannot be said of the stock market for any rigging, which is generally transparent to the investor and its pernicious consequences are known to the investor only after the damage is done. What is worse is that the riggers know and they are the consistent gainers on the upside and the down side.

      Further, without any limit to the number of players (investors) in the ring (on the other hand trapeze rings have limits to the number of artists it can hold) and with one ring being linked to another and that to another across the world, across time zones, I wonder if any of them, Kelly, Hull or White will be able to rationalize and justify the legitimized but specious gambling dens that stock markets are. It is not just the laws of physics or quantum mechanics that do not apply; the guiding principles of ethics also do not seem to apply. And as Raghuram Rajan surmises, at the crunch the nannies and curators (Stock Market watchdogs) are easily distracted by their own chatter.

      It could have been so once, but in an allegedly civilized world all is no longer fair in love and war. Hundreds of the guilty may go unpunished but no innocent should be convicted. Considering the futility of war, the argument of sacrificing hundreds of foot soldiers or innocent jihadists for the larger good is no longer acceptable. The right of governments to wantonly take shelter under any eminent domain is being seriously questioned. Thus, theorists and modern day soothsayers need to factor in such maxims and tenets into their mathematical models if they are to be called civilized models and not necessary evils. It is thus not a question of romancing financial markets but that of civilizing them.

    2. CommentedCox Andy

      Why the lack of foresight? It’s simple really: Capitalism is fundamentally an uncontrollable, conflicted, anarchic beast, driven by a few fundamental laws; such as ‘nothing is produced if a profit cannot be made from it’, ‘produce as cheaply as possible and set your price as high as possible’, ‘accumulate capital or go under in the remorseless struggle to gain a greater share of the market’, ‘externalise your costs, if you can’ and ‘annihilate the opposition’. With countless players in this scenario acting in accordance with these ‘laws’, the stage is set for constant instability. Small wonder no one can get a ‘handle’ on this kaleidoscopic phenomenon known as ‘the market’. Shifting circumstances merely inflame the fundamental conflicts of interest embedded in the system; the most fundamental of these, of course, being the intrinsic conflict of interest between labour and capital.
      It’s a system, in short, that is driven by greed and irresponsibility. Yet, in spite of what its apologists may claim, it’s an extremely inefficient system. To understand why, you need to look it from an entirely different perspective (See ), and what soon becomes apparent is that it is vastly wasteful of resources; human, natural, and manufactured. Capitalism has, in fact long outlived its progressive role. It’s time for it to be consigned to history. What needs to be established instead is a system of universal free access to all goods and services, with common ownership of the means of production, democratic decision-making, and the withering of the state.

    3. Commentedradek tanski

      The culprit is democracy.

      The voters want growth no matter what.
      The politicians get votes if they can promise growth.
      The economists provide differing options/opinions, some growth some not. The ones who give growth options are paid for them, the rest are ignored.

      Voters are not interested in economic propriety. Politicians who are, don't last very long.
      Economists are blamed for not delivering.

      Unfortunately democracy insists on resorting to expansionist policies which are the reason for the correcting recessions/depressions.

      Its obvious isn't it?

    4. CommentedAnton Könen

      Considering the, in the meantime well known, bogus background of the subprime crisis and the fraudulent and corrupt banking system in Europe, the question at all appears to me both, naive and misleading. First of all, there have been and still there are, several very professional economist been warning about the upcoming collapse. To discount them generally as „pessimists“ is simply ignorant. Second, with the bogus background mentioned, we would have to redefine what exactly do we want to analyse? As far as I kow, fraud, corruption, falsification of a balance sheet is not considered as a vital factor in any economic model. So, how to forsee the effects? And third, who should have been interested in foreseing it? Those participiants who had enough informations to know what had to happen made profit from this morbid system. I am, to be honest, quite disapointed, about the naive way of questioning and subsequent execution-in this forum and from such a top class economist. It sounds somehow ironic, that poor isolated academics, daring for public recognition, simply lost contact to the real world. Perhaps it would help to, lets say, visit one of the mobile home camps in the US, from those who lost their houses in the subprime, or go and have a coffee with one of millions of unemployed in Europe and the US as well, and discuss with them „real consequences“ of globalisation. This article does not cope with the social responibility that i see with the economic specialists of this world. If you are once asked why you did not warn, nobody will believe if your state“we just did not know“. You are, whether or not you want, a part of the system. So you knew, o re at least you could have known. This comment may sound emotional and yes, it is. It is almost unbearable to expeciance the cankerd and ironic way how banks, investment trusts and related political structures refuse to take resposibility. Word war II started very very similar. I am geting scared.......

    5. Commentedde Lafayette

      None of the answers apply, I submit.

      What happened was in the realm of fraud and chicanery. What model has those elements built into it?

      The Great Recession was provoked by a national Credit Mechanism Seizure in the fall of 2008, which occurred because of massive amounts of Toxic Waste discovered in securitized loans that rocked the financial foundation of the nation.

      What model would have predicted that? This outcome is a failure of oversight authorities who were asleep at the wheel. Who should have been doing the debt-instrument auditing necessary to have discovered it and then take the measures to stop it.

      The question remains nonetheless: "How do we prevent this from happening again?" Because it WILL happen again if permitted - due to a Tax Code that induces market manipulators on both Main Street and Wall Street to employ fraud in order to "get rich quick".

      The error was entirely human. The consequences were economic and, no, financial market-fraud is nowhere on the radar screens of most economists. (Some, in fact, did predict the calamity.)

    6. CommentedVictor Beker

      Of course, it is almost tautological that severe crises are essentially unpredictable. The real issue is that most mainstream economists did not even consider a crisis was possible: they not only assumed that the economy tends towards an equilibrium but also that it is a stable one. For them, any departure from equilibrium should be just a temporary one. In this respect, Rajan was a notable exception: his 2005 paper was a prescient analysis but nobody paid attention to it.

    7. CommentedWaleed Addas

      I agree that economics (and many other disciplines for that matter) has become too compartmentalized. The real problem facing the dismal science today is its lack of an anchor to a universal worldview or vision that looks at the human condition from a multi-disciplinary re-scoped approach--not only "money matters" but more also that 'morality matters' as well.

      As such, economics as it stands today (if it has any more legs to stand on!) will continue to face such crisis unless and until it re-thinks its basic premises and postulates on the nature and significance of the 'economic problem' and the purpose in life of the so-called "economic man".

      The whole is always greater than the sums of its parts!

    8. CommentedRonald Abate

      Bingo! It's insidious! I call it ideological cognitive impairment ("ICI"). You know where it is also prevalent? Climate science. Big time. Yes, CO2 is a greenhouse gas. Yes, during the 20th century the globe has gotten warmer as we continue to exit from the Little Ice Age and as we become more urban (the urban heat island effect). There is no scientific proof that anthropogenic warming will become catastrophic however (the climate models which predict CAGW require positive feedbacks in addition to the CO2 warming), yet the calls for drastic measures to reduce atmospheric CO2 are only necessary if the warming will indeed become catastrophic. So far, the observational data (which now include satellite and ocean temperature measurements that have no historical basis of comparison) also does not support the climate model predictions, yet there is a significant cohort of government and environmental NGO funded scientists who insist that the warming will be catastrophic.

    9. CommentedRonald Abate

      While there are naysayers, Shiller had done considerable research to back up his opinion. In 2004 I returned from 15 years working overseas and needed to find a place in which to resettle. I took this opportunity (I had no home to which to return) to take a grand tour of the U.S. and downloaded all of the Wholefoods store locations, as I figured they located their store in or near communities in which I would probably like to live. I was shocked at the prices, and since I had spent a decade in Singapore where home prices are very high, I should not have been. Then I would hear and read left wing economists lament the stagnant wages of the the middle class and listen to the advertisements for mortgages (no documentation, teaser rates) and I thought you had to be deaf, dumb and blind not to know it was a bubble. Needless to say I rented (in Las Vegas), developed a lease versus buy Excel program and continued to look. I purchased at the end of 2009 when the NPV per square foot to rent became more expensive than the NPV per square foot to purchase. I used square feet because there was no way that I would live in a community of homes of the size of the three bedroom rental in which I was living.

    10. CommentedJim Leis

      Out of all the memes explaining the crisis, most of them themselves ideologically driven and disappointingly simplistic given their authors, Mr. Rajan is beginning to hit the nail on the head.

      I do challenge him to consider that his article does not contravene the idea that the models employed by central banks are just plain inadequate, or even more likely, pretty much tangential to fundamental economies' health.

      In fact, we might also make the argument that Mr. Bernanke, and even Mr. Greenspan, were doing exactly the wrong thing when long term economic health needed them the most.

      If true, and I believe it is, then the whole idea of controlling interest rates and money supplies from a central authority based on economic models and yes, ideology, must be questioned. And that, economists have not even seriously considered in a formal, unbiased forum.

      There SHOULD be an existential discussion on economics given the crisis and the extreme influence economists exert on markets and nations, and we are not having it. On the contrary, economists themselves are distorting basic definitions (e.g. free markets, GDP, Keynesian theory) to retrench and support their positions, an alarming portrait of the dismal science.

    11. CommentedProcyon Mukherjee

      There is a great point in the last sentence, 'paying attention', and there is so much less attention to things that matter so much while we continue to be attentive to the trivia.

      Our deep attention to the trivia of information draws us away from the real hurdles that truth poses and we are more inattentive to the fundamentals therefore.

      Our aim should be to draw from the more general observations the specificity of truth which is more verifiable, more falsifiable and that is based on a pursuit of losing rather than gaining as we must believe that truth is never an end but a journey towards an end. Our ability to debate and to argue should not be enfeebled by the allegiance to different positions that we take, sometimes in different capacities as members of a society or an institution that we represent.

      As economists we will fail if we do not take careful note of this fallibility.

    12. Portrait of Pingfan Hong

      CommentedPingfan Hong

      The Queen asked a wrong question: it is simply not the job of academic economists to foresee the crisis, or even more precisely, economics as a discipline is not premarily in its essence about foreseeing a crisis.