Wednesday, September 9, 2009

Did economists ever get it right?

Paul Krugman has written a nice essay on the NY Times about How did economists get it wrong?. Other economists have written on the same topic: Eichengreen, Lane, Thoma, DeLong.

My reading of these articles is that there is a good deal of consensus around the following points:

1. Many (economists and non-economists) had expressed concerns prior to the crisis about economic imbalances such as excessive asset price appreciation or current account imbalances. They pointed out to the need of an adjustment, which could come in the form of a recession. As it has always been the case with recessions, forecasting the exact timing is not easy - it depends on how long imbalances are kept alive by markets, investors, policies (and luck).

2. There were several scenarios that were discussed prior to the crisis that could lead to a significant economic downturn. They involved a crash of the real estate market (which took place) and in some cases a reversal of capital flows as foreigners would stop lending to the US (or they would do so at much higher rates). This second scenario never materialized - the crash in real estate prices was enough.

3. Even among those who were concerned with the possibility of a crisis, very few understood the potential magnitude of the crisis, mainly because they could not foresee the collapse of the financial system that we witnessed a year ago. Here is a quote from Frederic Mishkin (who was a member of the Board of Governors, Federal Reserve 2006-08) in August 31 2007:

“The big gains in housing prices we have seen here and in many other countries have raised concerns about what might happen to economic activity if those price gains are reversed. Developments in the housing market can also affect credit markets. Furthermore, problems in the subprime mortgage market have led investors to reassess credit risk and risk pricing, thereby widening spreads in general and weakening the balance sheets for some financial institutions. Fortunately, the overall financial system appears to be in good health and the US banking system is well positioned to withstand stressful market conditions.”

Clearly, our knowledge of what was happening inside the financial system and the associated risk was very limited. This is a failure of regulation and we learned the lesson the hard way.

4. No doubt that some of the research that was done by economists (those in academia) did not provide any clue about what was about to happen. As Phil Lane argues in his article, this is partly a result of specialization, not all researchers are into the business of forecasting economic downturns. But there is also no doubt that some of the research in macroeconomics has been anchored in models that do no recognize enough failures in markets or deviations from rational behavior to produce or understand some of the phenomena that led to the current crisis. Part of this is because of ideological reasons (some want to believe that markets always work), part of this is because the "beauty" of dealing with simple models (the argument made by Krugman in his article).

One thing that I find missing in all those articles is to know whether there was any difference between the current crisis and the previous ones. I am not sure there is much difference. Prior to the (mild) recession of 2001 we also witnessed very similar dynamics: many expressed concerns about the valuation of stocks (more so for tech stocks). But they called the crisis way before it happened. Once it happened, we all asked the question "How did we get it so wrong?". The difference with the current crisis is that this one is bigger, so more questions are being asked. Also, economic policy has played a much stronger role during the crisis, which has probably led to a stronger debate around economics.

It is also interesting to see that during the boom year, there was as much skepticism of economists' forecasts as today so even if some economists were getting it wrong, it is unclear how much they were driving market expectations or investment and spending decisions.

We will have to wait for the next crisis and see if things have changed or we just need to conclude that economists "will never get it right".

Antonio Fatás