Raghu Rajan asks why did economists not spot the crisis?

In his blogpost, Raghu Rajan reflects why economists did not spot 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!

Rajan says answers so far are – lack of models, free market ideology and system bribed economists to stay silent. He says they are not really correct. Though last point is worrisome: 

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.

Interestingly, there was a recent hearing in House Committee on Financial Services. I noted at the end of the testimonies, economists are asked to disclosed things which Rajan mentioned. They are supposed to testify whether they have received any grant related to the subject they have testified on. If yes, you are supposed to disclose the amount. In a way, economists might not like to be part of code  of conduct, the government is tying the lose ends by itself.

Meanwhile, DeLisle Worrell, Governor of the Central Bank of Barbados says he is searching for Practical Economics. He made waves earlier with his superb speeches questioning economics relevance in today’s world.

He picks the case of monetary economics. Say inflation is higher than targeted. The centrak bank raises interest rates hoping inflation will fall. But c-banks need more information than this plain theorertical know-how:

In practice the central banker needs more precise information. What quantity of additional treasury bills should the central bank buy, to reduce inflation by 3 percentage points? To provide the answer, at a minimum, we need to know:

1. How banks will react to the central bank’s purchase of additional T-bills. How much excess liquidity do they have? Would it be profitable for them to source additional liquidity abroad, as domestic interest rates rise? Should they do so, would the exchange rate tend to appreciate? Would banks be inclined to change domestic deposit or loan rates?
2. Whether, when and how will interest rates rise? Will rates rise all along the yield curve? What lag can be expected? Will rates increase on both sides of banks’ balance sheets? Will the spread narrow, widen or stay the same?
3. If the T-bill purchases do result in interest rate increases, by how much will banks adjust their holdings of cash and liquid items?
4. Will there be any adjustment in loans, and if so, how large an adjustment?
5. Will there be any cut in aggregate expenditure, as a result either of an increase in loan rates (if they increase) or a reduction in loan supply (if there is a reduction)? If so, what is the elasticity of response?

Unfortunately, we can seldom offer a definitive answer to these questions. As a result, the analysis of monetary policy in central bank reports, and in the economic media, seems curiously incomplete. They describe what has been done with interest rates and open market operations, and what, if anything, has happened to bank liquidity, but they never bring the story to a conclusion, to say what effect policy actions have had on output or inflation, even in the broadest terms. We simply do not have the information we would need to make such an assessment.

Does this mean we are helpless? Not really.

Does that mean we are in a hopeless situation, and that we can do nothing to stabilise the economies of small open economies? I do not think so. However, the search for practical advice, advice that a policy maker can actually put into practice and measure its impact, takes us beyond conventional economics. To begin with, the policy objective of choice should be economic stabilisation, not inflation control. Policy makers need to choose as target a variable over which they can have some control. We cannot target inflation at 5 percent if 80 percent of that inflation is imported from abroad, and import prices rise 10 percent. Whatever our policy, domestic prices are going to rise at least 8 percent.

A more useful objective, in the open economy, is to stabilise external payments and receipts, and maintain a level of foreign exchange reserves which market agents find to be adequate. That creates a stable environment for business and investment planning, and is therefore the best platform for sustained economic growth. As a result, this is an objective which resonates with the companies and households whose collective decisions will result in the outcome of whatever policy is chosen. Practical policy requires us to start with this objective, and to find the economic policies that may be employed to achieve it.

Hmm..  Food for thought…

2 Responses to “Raghu Rajan asks why did economists not spot the crisis?”

  1. soe Says:

    Some more food for thought: links to books, articles of the economists who did spot the crisis:


    Direct link to pdf file of a paper titled Who Predicted the Bubble? – http://mises.org/journals/scholar/Thornton6.pdf

    So, I have an impression that failing to spot the crisis wasn’t a collective failure of economists, but rather a collective failure of econometrics, of economics build on unrealistic mathematical models.

  2. soe Says:

    I was trying to post a comment yesterday, but apparently, I forgot to click on ‘Post Comment’ button (or maybe I did but the comment got lost somehow…).

    Many economists did spot the crisis. You can find list of articles (even from 2002 and older) here: http://mises.org/daily/3128

    I’m sure the list is incomplete. And so it is unhonest or uninformed to say that failure to spot the crisis was collective failure. No, not all economists failed to predict it.

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