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Why did economists fail to predict the crisis

(chinadaily.com.cn)
Updated: 2009-05-25 14:26

Wall Street bankers and deal-makers top it, but banking regulators are on it as well, along with the (US) Federal Reserve. Politicians and journalists have shared the blame, as have mortgage lenders and even real estate agents.

But what about economists? Of all the experts, weren't they the best equipped to see around the corners and warn of impending disaster?

Indeed, a sense that they missed the call has led to soul searching among many economists. While some did warn that home prices were forming a bubble, others confess to a widespread failure to foresee the damage the bubble would cause when it burst.

Some economists are harsher, arguing that a free-market bias in the profession, coupled with outmoded and simplistic analytical tools, blinded many of their colleagues to the danger.

"It's not just that they missed it, they positively denied that it would happen," says Wharton finance professor Franklin Allen, arguing that many economists used mathematical models that failed to account for the critical roles that banks and other financial institutions play in the economy.

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"Even a lot of the central banks in the world use these models," Allen says. "That's a large part of the issue. They simply didn't believe the banks were important."

Over the past 30 years or so, economics has been dominated by an "academic orthodoxy" that says economic cycles are driven by players in the "real economy" - producers and consumers of goods and services - while banks and other financial institutions have been assigned little importance, Allen says. "In many of the major economics departments, graduate students wouldn't learn anything about banking in any of the courses."

But it was the financial institutions that fomented the current crisis, by creating risky products, encouraging excessive borrowing among consumers and engaging in high-risk behavior themselves, like amassing huge positions in mortgage-backed securities, Allen says.

As computers have grown more powerful, academics have come to rely on mathematical models to figure how various economic forces will interact. But many of those models simply dispense with certain variables that stand in the way of clear conclusions, says Wharton management professor Sidney G. Winter. Commonly missing are hard-to-measure factors like human psychology and people's expectations about the future.

Among the most damning examples of the blind spot this created, Winter says, was the failure by many economists and business people to acknowledge the common-sense fact that home prices could not continue rising faster than household incomes.

Says Winter: "The most remarkable fact is that serious people were willing to commit, both intellectually and financially, to the idea that housing prices would rise indefinitely, a really bizarre idea."

Although many economists did spot the housing bubble, they failed to fully understand the implications, says Richard J. Herring, professor of international banking at Wharton.

Among those were dangers building in the repossession market, where securities backed by mortgages and other assets are used as collateral for loans. Because of the collateralization, these loans were thought to be safe, but the securities turned out to be riskier than borrowers and lenders had thought.

In a critical paper titled "The Financial Crisis and the Systemic Failure of Academic Economists," eight American and European economists argue that academic economists were too disconnected from the real world to see the crisis forming.

"The economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its dimensions once it started to unfold," they write. "We trace the deeper roots of this failure to the profession's insistence on constructing models that, by design, disregard the key elements driving outcomes in real world markets."

The paper condemns a growing reliance over the past three decades on mathematical models. These models, it says, improperly assume markets and economies are inherently stable, and disregard influences like differences in the way various economic players make decisions, revise their forecasting methods and are influenced by social factors.

Reproduced with permission from Knowledge@Wharton, http://knowledgeatwharton.com.cn. Trustees of the University of Pennsylvania. All rights reserved.