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Why did Economists Miss the Financial Crisis?

Wall Street in Crisis
CNBC.com
Wall Street in Crisis

University of Chicago finance professor Raghu Rajanis has written an interesting article about why academic economists failed to predict the financial crisis.

He begins with an anecdote.

The Queen of England visited the London School of Economics recently and asked the luminaries their assembled the following question: "Why Did Economists Not Spot the Crisis?"

It's an excellent question, Your Majesty. (You were tough as nails during The Blitz—and is sounds like you have more common sense than a cocktail lounge full of business journalists. It's almost enough to make me doubt my republican sensibilities.)

After dismissing the notion that economists lacked the formal models to predict the crisis, Rajanis observes:

"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."

So, in effect, not only do the models exist—but they were too rigidly adhered to, because people rarely behave rationally, as models suggest they ought to.

Ideological inflexibility notwithstanding, Professor Rajanis believes there are three principle causes for the failure:

First, Compartmentalization: "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, in order to see the crisis coming, you had to know something about each of these areas, just like 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."

I'm not an academic, but it certainly sounds like an idea that has merit. (Although I submit that my only evidence for this is the silliness of many of the academic articles I discover doing research on Google. Sometimes it reads as though academics are in a race to see who can parse the narrowest topics most finely.)

Second: Difficulties with forecasting. "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."

It's difficult to predict stuff—because it hasn't happened yet. I'll buy that.

Third: Disengagement: "The danger, though, 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!"

Yep: Ignoring stuff is bad.

Perhaps it's best not to expect too much on this topic.

If there were an easy answers for why economists failed to see the crisis before it happened we would know them by now.

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