Why Did Economists Miss the Crisis?

Raghuram Rajan at the Chicago University Booth School of Business. He is not in their Economics Department. He was chosen by fellow economists as the economist with the most important ideas in a post-crisis world. See here (ht: Ram Narayan).  Hence, his comments carry significance. His latest blog post is on the question of why economists failed to see the crisis of 2008. [It is a different story as to whether the y would see the crisis of 2012 coming] 

I do not know if the view that is gaining ground is that the system bribed economists to stay silent. I am not going to contest Raghu on that one.

He dismisses ideology since both believers in market efficiency and non-believers missed predicting the crisis. He dismisses corruption though he acknowledges enough instances of bias to welcome disclosure of conflicts of interest. I hope that disclosure happens more often. Economists call for transparency and disclosure of information from governments. It is about time that they turned the spotlight on themselves on that issue.

He zeroes in (if I understand him correctly) on compartmentalisation and specialisation as potential causes. Economists are too narrowly focused on selected areas within the broad discipline and that there is no reward for generalists within the academic community. Again, he may well have a point there. He should know better.

I would supplement his analysis with the following observations:

(1) He dismisses the role of ideology too quickly. Some one who wrote the brilliant book, ‘How to save capitalism from capitalists’ should not be too dismissive of the role of ideology in precipitating the crisis and hence those ideologically inclined would not have seen it as an issue and a risk. Market efficiency might be technically defined as a statement that securities prices reflect all available public information and hence return on securities is essentially unforecastable based on known public information.

But, that narrow definition has not prevented Wall Street from appropriating for itself the advantages of the theory:  since they are participants in a market that is deemed efficient and hence, their decisions and actions must be efficient! Otherwise, the market would not be efficient. Therefore, the government should lay its hands off Wall Street.

Those who believed in financial market efficiency did not ask hard questions enough on how financial market efficiency came to stand for ‘hands off’ policy towards the financial sector.

Hence, ideology played a role in precipitating the crisis and in making many economists blind to its role in the crisis.

(2) I suspect that Raghu is again focusing on the US centric crisis when he refers to ‘US politicians pushing the private sector into financing affordable housing’. This crisis was global. There were housing bubbles in many countries.  The reason why not many economists raised a flag is due to their belief in ‘Great Moderation’. The fact that many picked Ben Bernanke as the most currently influential economist is proof of that. See here. The Federal Reserve Chairman believed in the role of policymakers in bringing about great moderation.

Most of them believed that, due to the crafty steering of monetary policy in the 1980s and 1990s, Western policymakers had conquered business cycles and hence risks have been largely eliminated or diversified away.

They did not believe that the great moderation of the 1980s, 1990s and partially up to 2007 was due to special factors: Commodities were declining in prices up to the end of the millennium (excess supply, slow growth in world demand, accent on conservation, climate change had not begun, etc.), labour power had been tamed by Mrs. Thatcher and Reagan, the European Union was focused on creating monetary union with low inflation, demographics were in a sweet spot in the developed world and ensured moderate to strong growth, internet and TMT boom boosted productivity, consumer choices and lowered prices.

Once these special/one-off factors began to fade, the moderation disappeared and cycles re-appeared. Economists turned policymakers, basking in their own glory, failed to see that coming nor did other economists who were cheerleading them. There were several honourable exceptions.

So, what is my submission?

Raghuram Rajan is right about academics’ specialisations and narrow focus, lack of incentive for generalisation, being responsible for academic economists missing the crisis.

Just yesterday, I was discussing with a distinguished economist who refused to accept that easy money policy of the Federal Reserve was responsible for the rise in the prices of commodities or for speculation in commodities. He argued that correlation was not the same as causation. This argument vindicates lack of experience in the real world of financial markets.

Nonetheless, specialisation and compartmentalisation are only partial answers.

Ideological belief in market efficiency (broadened to include acceptance of the efficiency of financial market participants!) and hubris were other contributory factors.

Postscript: Generalists-economists exist outside academics. Economists and strategists working for investment banks see financial market action. They could observe mispricing of risk: abundant faith in carry-trade, currencies out of alignment with fundamentals, massive compression of spreads on high-yield and emerging market bonds, etc.. All of them were evident leading up to 2007-08. But, for the most part, their incentives are aligned with generating revenues for their firms and not with warning about risks in the financial markets.

Originally published at The Gold Standard and reproduced here with permission.

One Response to "Why Did Economists Miss the Crisis?"

  1. Guest   February 11, 2011 at 9:53 am

    This article has an interesting way to describe the financial crisis:http://www.mindfulmoney.co.uk/wp/all-errors-are-human-errors/It says – Any sufficiently complex, tightly coupled system will fail sooner or later, the example then used is the meltdown at Three Mile Island nuclear power plant.their system was too complicated, so that even those who were experts in the areas didn’t not know how to assess what was going on, therefore when something started to go wrong, everyone was ‘completely lost’. even though the systems were ones they set up and they believed in them but the confidence was misplaced, the complexity of the system poorly understood.The same can be said about the financial crisis.All errors are human errors – so its really no surprise that the financial crisis was ‘avoidable’