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Thread: Why Did Economists Not Spot the Crisis?

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    Why Did Economists Not Spot the Crisis?

    Raghuram Rajan speaks on the topic:


    CHICAGO – At the height of the financial crisis, the Queen of England asked my friends at the London School of Economics a simple question, but one for which there is no easy answer: Why did academic economists fail to foresee the crisis?




    There have been several responses to that query. One is that economists simply lacked models that could account for the behavior that led to the crisis. Another is that economists were blinkered by an ideology according to which a free and unfettered market could do no wrong.

    Finally, an answer that is gaining ground is that the system bribed economists to stay silent.




    In my view, the truth lies elsewhere.




    It is not true that we academics did not have useful models to explain what happened. If you believe that the crisis was caused by a shortage of liquidity, we had plenty of models analyzing liquidity shortages and their effects on financial institutions. If you believe that the blame lies with greedy bankers and unthinking investors, lulled by the promise of a government bailout, or with a market driven crazy by irrational exuberance, we had studied all this too, in great detail.




    Economists had even analyzed the political economy of regulation and deregulation, so we could have understood why some US politicians pushed the private sector into financing affordable housing, while others deregulated private finance. Yet, somehow, we did not bring all this understanding to bear and collectively shout out our warnings.




    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. The theory does not say that markets cannot plummet if the news is bad, or if investors become risk-averse.




    Critics argue that the fundamentals were deteriorating in plain sight, and that the market (and economists) simply ignored it. But hindsight distorts analysis. We cannot point to a lonely Cassandra like Robert Shiller of Yale University, who regularly argued that house prices were unsustainable, as proof that the truth was ignored. There are always naysayers, and they are often wrong. There were many more economists who believed that house prices, though high, were unlikely to fall across the board.




    Of course, these expectations could have been distorted by ideology – it is hard to get into the past minds of economists. But there is a better reason to be skeptical of explanations relying on ideology. As a group, neither behavioral economists, who think that market efficiency is a joke, nor progressive economists, who distrust free markets, predicted the crisis.




    Could it be corruption? Some academic economists consult for banks or rating agencies, give speeches to investor conferences, serve as expert witnesses, and carry out sponsored research. It would be natural to suspect us of bias. The bias could be implicit: our worldview is shaped by what our friends in industry believe. Or it may be an explicit bias: an economist might write a report that is influenced by what a sponsor wants to hear, or give testimony that is purely mercenary.




    There are enough instances of possible bias that the issue cannot be ignored. One remedy would be to ban all interaction between economists and the corporate world. But if economists are confined to the ivory tower, we may be unbiased but also ignorant of practicalities – and thus even less capable of predicting problems. One way to restore trust may be disclosure – for economists to declare a monetary interest in a particular analysis and, more generally, to explain who pays us. A number of universities are moving in this direction.




    But I believe that corruption is not the main reason that the profession missed the crisis. Most economists have very little interaction with the corporate world, and these “unbiased” economists were no better at forecasting the crisis.




    I would argue that three factors largely explain our collective failure: specialization, the difficulty of forecasting, and the disengagement of much of the profession from the real world.




    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.




    Even if they did, they would shy away from forecasting. The main advantage that academic economists’ have over professional forecasters may be their greater awareness of established relationships between factors. 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.




    The meager professional rewards for breadth, coupled with the inaccuracy and reputational risk associated with forecasting, leads to disengagement for most academics. And it may well be that academic economists have little to say about short-term economic movements, so that forecasting, with all its errors, is best left to professional forecasters.




    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!
    Chicago Booth Blog: Fault Lines by Raghuram Rajan*-*Fault Lines by Raghuram Rajan

    Note, Mr. Rajan is considered to be an up and coming Economist and a particularly someone who can successfully claim authority and credibility to talk about this crisis and forecasting because he arguably forecast the crisis correctly.

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    People need to remember and take into account that with due respect to studies and theories, it's still impossible to predict the beyond immediate future with a 100% success rate. It's not even possible to predict the direct future with a 100% success rate. I can drop a ball 99 times and it will always fall and hit the floor, but on the 100th try the earth's core could stop spinning, gravity will fail and the ball (and I) will float instead of drop. Realistic? No. Probable, not very, but probable nonetheless
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    Quote Originally Posted by bigross86 View Post
    People need to remember and take into account that with due respect to studies and theories, it's still impossible to predict the beyond immediate future with a 100% success rate. It's not even possible to predict the direct future with a 100% success rate. I can drop a ball 99 times and it will always fall and hit the floor, but on the 100th try the earth's core could stop spinning, gravity will fail and the ball (and I) will float instead of drop. Realistic? No. Probable, not very, but probable nonetheless
    I remember there was a mathematician who wrote about the uncertainty of seemingly certain things, but I just can't seem to remember his name...

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    Bah............greed pure and simple on the part of the minority and screw the majority.....dress it how you want.
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    Former Staff Senior Contributor Ironduke's Avatar
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    Alan Greenspan: "irrational exuberance"

    "Irrational exuberance" is a phrase used by the then-Federal Reserve Board Chairman, Alan Greenspan, in a speech given at the American Enterprise Institute during the Dot-com bubble of the 1990s. The phrase was interpreted as a warning that the market might be somewhat overvalued.
    Irrational exuberance - Wikipedia, the free encyclopedia

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    The whole economic system is based on lies and lies alone. It's like with the US monetary system: most of the people think dollar is a federal state currency. But given the fact that since 1913 the Federal Reserve is owned by European top banking families, is it?

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    Quote Originally Posted by Fred View Post
    The whole economic system is based on lies and lies alone. It's like with the US monetary system: most of the people think dollar is a federal state currency. But given the fact that since 1913 the Federal Reserve is owned by European top banking families, is it?
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    Turbanator Senior Contributor Double Edge's Avatar
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    Quote Originally Posted by Ironduke View Post
    Alan Greenspan: "irrational exuberance"


    Irrational exuberance - Wikipedia, the free encyclopedia
    Yeah, but he mentioned in one of his talks that he could not explain how greed could overcome the natural instinct for self-preservation.

    That's why companies went bust or had to be taken over by govt.

    They had no clue that what they were doing would take themselves down let alone others.

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    I can drop a ball 99 times and it will always fall and hit the floor, but on the 100th try the earth's core could stop spinning, gravity will fail and the ball (and I) will float instead of drop
    Wait..earth gravity is caused by its mass, not its core (spinning or not). Your scenario should lead to the disappearance of the magnetic field..at least if I remember my physics classes correctly..which I had a decade ago...and this has not really much to do with the actual topic, so I better stop rambling.

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    Raghuram Rajan says all the right things about the role of economists, but he fails to point out that economists had no way of knowing that the quality of mortgage-backed derivatives that the investment banks were selling around the world had descended to the level of crap near the end of the housing boom. When one considers that even the banks, whose failure precipitated the crisis, didn't wake up until too late, how can one expect outsiders like economists to know. It was an investment analyst who discovered that the paper the banks were buying from mortgage companies to create derivatives was under-performing. Of course, there is a casual chain of circumstances that led to that discovery, for example a ridiculously low prime rate, the availability of no-doc mortgages, inadequate SEC regulation, and, yes, that forever constant, greed

    I wouldn't fault the economists for failing to see this particular crisis. Their job is to weigh the various elements of the economy and project future behavior, not to conduct due diligence on equities being traded in the market. They use metrics produced primarily by the government. If the government did not know the poor quality of mortgages, how could economists know. So, they didn't know a key metric, that many people with low incomes were getting mortgages of $2-3-400K. Those people got away with it as long as the boom kept going. The object was to buy the house, wait for it to appreciate in value, take out an equity loan on it to cover the payments, and flip it to another buyer before the money ran out. Unfortunately, the market ran of buyers.
    Last edited by JAD_333; 15 Feb 11, at 00:42.
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    Official Thread Jacker Senior Contributor gunnut's Avatar
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    Quote Originally Posted by Double Edge View Post
    Yeah, but he mentioned in one of his talks that he could not explain how greed could overcome the natural instinct for self-preservation.

    That's why companies went bust or had to be taken over by govt.

    They had no clue that what they were doing would take themselves down let alone others.
    Self preservation did overcome greed. Those who got out before the crash did so. Some people made huge sums of money doing just that. Those who didn't get out in time weren't more greedy than anyone else. They just had bad timing.
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    I did see some reading from Economists warning of the "housing bubble burst," BUT they never went into depth about the severe consequences, so it was taken lightly.

    I also believe it was greed, pure and simple, and some were smart enough with the timing to get out, and some were not.

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    The motivation was definitely greed as was noted by several of the members, but Mr. Rajan speaks more of the way economists these days go about business as leading them to overlook serious problems and trends they otherwise should not have.

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    By the way, this is off-topic, but is it just me or does Mr. Rajan look like a Indian version of George Clooney? He's definitely got the suave and intelligent look down.



    Heh, I get the feeling he got his fair share of girls when he was younger.

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    Turbanator Senior Contributor Double Edge's Avatar
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    Quote Originally Posted by gunnut View Post
    Self preservation did overcome greed. Those who got out before the crash did so. Some people made huge sums of money doing just that. Those who didn't get out in time weren't more greedy than anyone else. They just had bad timing.
    Umm, nobody got out in time, there were those that were saved and those that were not.

    How do you explain Lehman being leveraged at 30 to 1.

    Imagine getting 30 mortgages on one house, and doing it with a straight face.

    Isn't that a ridiculous amount of risk to be exposed to.

    These ppl have to know about timing, their profit lines depend on it.

    How does it appear when a fund manager has to explain that there have been losses because he did not pull out in time ?

    Barings bank went down because of one rogue trader. How many did Lehman have ?

    And I did not hear any mention of rogue traders at Lehman.

    These guys are supposed to know what they are doing, but they got blindsided, and they weren't the only ones. Is there any way you can prevent that from happening in the future ?

    We can have lots of regulations to protect against this but that only gets in the way of profits.

    When times are good, those regulations get gradually stripped away and the cycle repeats itself.

    So I ask again, how can greed overcome the natural instinct for self-preservation ?
    Last edited by Double Edge; 15 Feb 11, at 16:07.

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