Jul 19 2009, 8:03PM
Economists Take it on the Chin
Three articles in the July 16 issue of The Economist magazine criticize the economics profession for its failure to anticipate the financial crisis of last September, and the ensuing economic crisis, and for its inability to agree on what should be done to speed recovery. These articles, which can be found at
http://www.economist.com/opinion/displayStory.cfm?story_id=14031376&source=hptextfeature
http://www.economist.com/displaystory.cfm?story_id=14030288, and
http://www.economist.com/displaystory.cfm?story_id=14030296,
are well worth reading. Both the economists and government officials (often both) have received too small a share of the blame for the current economic troubles. This is a theme I sounded in my book and in several of my blog entries, but it has received little attention. The Obama Administration, with its ambitious public programs, does not want to accuse government of incompetence, and the economists who manage and advise the government's economic policies, many of whom were complicit in the failures of anticipation and response, do not wish to acknowledge their errors and those of their fellow economists. Furthermore, Congress and the public, and much of the media, do not understand macroeconomics or financial economics, and so they are drawn to a populist theory in which the economic crisis is attributed to the avarice and folly of financiers and the vulnerability of gullible consumers. The populist theory suits the Administration and the economics profession just fine, as it directs attention away from government failure and the failure of professional economists inside and outside the government.
Congress has just appointed a 10-member Financial Crisis Inquiry Commission, headed by a former treasurer of California named Phil Angelides, to investigate the origins of the financial crisis. The commission is bipartisan rather than nonpartisan; there are six Democrats and four Republicans, and most of them have strong partisan affiliations, as revealed by their campaign contributions. There is anxiety about how searching and professional the commission's inquiry will be. See, e.g., www.whatcausedthecrisis.com. I share that concern. None of the members, I believe, is a professional economist, and this will make the commisson's choice of a staff director critical. But if the economics profession does not understand the financial crisis, where is the commission going to find a competent staff director? It will be difficult, but there are a number of competent young economists who have not yet taken sides on the burning issues of macroeconomics and finance theory and could guide a neutral inquiry into the causes of the crisis.
My worry is that, because of the complexity of the economic issues and the difficulty of finding economists who are not committed to one side or the other of the methodological and ideological divides that permeate macroeconomics, the commission will devolve into an investigation of frauds and errors (and there were plenty of both, I am sure) of lenders and borrowers during the housing and credit bubbles. There may be some value in such an investigation, but it will not get to the root causes of the crisis or point the way toward economically sensible reforms. There are plenty of legal tools already for dealing with fraud, and errors (for example in assessing the risk of securitized debt) tend to be self-correcting. An investigation that does not delve into the failures of regulation (including the Federal Reserve's monetary policies and the SEC's regulation of broker/dealers) and of responses to the crisis will be severely truncated.
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Richard A. Posner
I am not yet persuaded that "Macroeconomics" failed in terms of being an inadequate body of knowledge. I think it is more likely that analysts failed to construct their models and perform their simulations in proper accordance with the theory by failing to seriously consider the existence, and potentially profound effect of a bubble in housing prices.
The three fundamental questions that face contemporary Macroeconomics and the evaluation of any criticisms against the field are 1. What got us into the crisis, 2. How will the crisis evolve, and 3. What government policies will get us out of it in the optimal manner.
Question 2 is a good one to test the models - and hopefully we'll learn how to refine them when we get through this downturn. Question 3 is, unfortunately, part of that great divide Judge Posner mentioned. But let's consider questions 1. The extremely simplified half-answer is:
"The bursting of an enormous nationwide (though concentrated in the Southwest), last-fool, frenzied bubble in real estate fueled by rampant speculation, and ultra-cheap financing (caused by too-low interest rates) the terms of which became increasingly easy and risky so as to eventually border on a complete failure of the banking industry to actually underwrite their loans. Much of this behavior was based on little more than an unjustified faith in the notion that 'house prices can't go down' because they hadn't in the recent past. Furthermore, 'innovations' in financial arrangements allowed, among other things, homeowners to withdraw all their equity from their residences during the bubble's dramatic overshoot, which in turn stimulated employment, consumption, and investment to levels far above equilibrium."
My own home loan from Countrywide was profoundly cheap and essentially non-underwritten, so I know a little bit about the phenomenon.
Now, I've read the Economist articles and dozens of other similar posts, but I must say, so far, I've been unimpressed with the quality of the case against the field insofar as the first question is concerned. Just because most of the analysts' predictions were incorrect does not necessarily imply that they made these predictions properly and in accordance with the basic conclusions of the field.
Surely, it is possible that they mostly shared a kind of common mistake or psychological bias in the way they were handling their mathematical simulations. I think this mistake is, essentially, they failed to take the house-pricing situation seriously despite all the worrying signs being very much in the data. Nothing in Macroeconomics told any of the analysts or modelers to basically ignore the housing variable in their equations, but this was common.
Many analysts and financiers and even academic scholars betrayed their own "Past Results do not guarantee future performance" disclaimers - and confidently continued to use indexes with tiny house-price multipliers from a small set of recent empirical data. Is it more fair to attribute this failure to "Bad Macroeconomics" than to "Bad Analysts"?
Those few observers who, when spurned by the rapid increase in pricing, did delve into housing realized quickly what a large mistake this low-weighting had been. Roubini, Shiler and others did not need to discover or develop new concepts, they merely had to use the data before them instead of ignore it based on the 'faith' described above. When they then went on to perform their new analyses (using current and well-established Macroeconomics concepts) they came to similar and accurate - that is, catastrophic - conclusions.
I would highly recommend that readers consider this post (and read all the comments) on Angrybear from the Economics blogger Calculated Risk, while keeping in mind that it was written over 4 years ago:
http://angrybear.blogspot.com/2005/04/housing-speculation-is-key.html
Now, the phenomenon of speculative bubbles is nothing new and it is certainly far from unstudied. The Dutch Tulipmania is the famous case, and it is from nearly 400 years ago, with bubbles in one thing or another appearing periodically ever since and in most economies on the planet. Japan's real estate and American technology stocks are just two of the most recent examples.
Now, it is one thing to say that many Macroeconomists failed either to detect or adequately consider the importance of this particular bubble, and an entirely different thing to accuse the field of Macroeconomics as to be one lacking in basic explanations for them or dynamic models that could satisfactorily simulate the development of an economic situation in the face of a huge overshoot.
My point is this - I'm not yet persuaded that what went wrong here was a fundamental problem in current Economic theory - something akin to Physics prior to the development of Relativity and Quantum theories. I am more inclined at present to think that this was a typical, if massive, bubble, and things went more-or-less the way the theory says they will when such a thing occurs.
Why most of the human beings responsible for applying the theory overconfidently and unjustifiably discounted this important variable, I am not sure. But I think this human question is the one that ought concern us more than the theoretical one.