By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.
Apologies to both Clemenceau (Prime Minister of France 1917-1920) and General Jack D. Ripper (Dr. Strangelove 1964)
The recent crisis and continuing economic and financial dislocations has led many to question the usefulness of the current macroeconomic paradigm, if not economics more generally. Raghuram Rajan, whose paper, “Has Financial Development made the World Riskier,” was summarily dismissed at the Fed Jackson Hole Conference in 2005, has recently posted a piece titled “Why Did Economists Not Foresee the Crisis?” In this piece, Rajan rejects three popular explanations for the failure of economics and economic policy, i.e. the absence of “models that could account for the behavior”, “ideology”, and “corruption”. Rajan offers alternative explanation(s): “I (Rajan) would argue that three factors largely explain our (economists) collective failure: specialization, the difficulty of forecasting, and the disengagement of much of the profession from the real world.” The logical conclusion of Rajan’s explanation(s) is that to avoid future crises, the role of economists, or at least academic economists, in the policy formulation process should be reduced. More troubling yet for economists, including Rajan, is some recent work by Frydman and Goldberg which argues that current economic models are inherently flawed.
Rajan dismisses the argument that economics lacked relevant models. He cites the fact that academic economists have studied and modeled many of the factors that contributed to the crisis. Rajan does, however, cite the compartmentalization of economics which leaves macroeconomists ignorant of findings in other sub-disciplines of economics.
In Rajan’s view, the inability to forecast accurately reflects shortcomings in the current model. All models of the economy abstract from the complexities of the economy and financial system. Models are simplifications of realty. Hence the models are incorrect. (We will return to this point later.) The only questions are how large and costly will the model-driven errors be.
Observers should not be surprised by the fact that the models employed by economists contained simplifying assumptions. However, they should be disturbed by the recent performance of policymakers. They ought to ask the question: why did economists remain wedded to their model despite the growth of all the macro-economically important economic and financial imbalances and unsustainabilities that existed in the years prior to the crisis?
Rajan rejects the argument that it was an ideological commitment to market efficiency that led economists to undue faith in the model. Rajan cites the fact that both behavioral economists who reject market efficiency and progressive economists who reject free markets also failed to see the crisis coming.
However, economists and policymakers in the US dismissed evidence of numerous unsustainabilities, as well as rejected warnings by the likes of Rajan, Shiller, White, and ironically Kohn formerly of the Board of Governors. In an op-ed piece, Shiller blamed the failure to foresee the crisis on group think. (here) He cited as evidence his experience on an FRBNY advisory board. In a 2003 paper, Kohn cited potential risks in unsustainabilities in the housing market, consumer expenditures and the build-up of debt. However, judging by his response to Rajan at the 2005 Jackson Hole Conference, he didn’t see problems or risks despite the large and growing unsustainabilities in areas he had cited in 2003.
The narrow specialization of academic economists is consistent with this highly specialized group think dominated the policy perspective. This is also reflected in the job description offered by one former member of the Board of Governors, appointed during the run-up to the crisis. The appointee said something to the effect that his job on the Board was helping Bernanke implement inflation-only targeting. This reflects a narrow anti-intellectual mindset. This view of the job of a central banker implies that the appointee’s model of the economy had morphed from an engine of analysis (potentially one of many) in to a set of intellectual blinders complete with an disregard for a governor’s regulatory responsibilities. Hence It is probable that the imbalances and unsustainabilities were ignored because they were at variance with the group-think-endorsed model and were a)implicitly and without thought deemed to be unimportant, or b)if addressed would have ruined or delayed the proof the their model was the correct one.
Rajan rejects the argument that consulting contracts and other outside (outside of academia) money had corrupted economics. The view that economics had been corrupted became more popular when it became widely known that former Fed Governor Mishkin, while still an academic, had been paid for a review of developments in Iceland by Icelandic groups with an interest in promoting financial markets and institutions in Iceland. Two observations:
1) Did anybody ever think that he did it for free? (Do academics, economists, psychologists, sociologists, chemists, statisticians generally consult for free?); and
2) To suggest that this corrupted Mishkin is an insult to the Icelanders who hired him. Does anyone think that they did anything but search out someone with proper credentials and who was already predisposed to produce a favorable review?
Rajan points out that that the vast majority of economists who subscribed to the views held by Mishkin never got a dime from Iceland or any other outside source.
Rajan also cited the disengagement of much of the profession from the real world as a reason why economists failed to foresee the crisis:
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 danger 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’s explanation for the failure of the academic economics profession to foresee the crisis should be more disturbing to academic economists than the popular criticisms. The shortcomings mentioned in the popular explanations are more easily corrected. The vast majority of academic economists have not benefitted at all from lucrative outside consulting contracts. There exists a spectrum of opinions within the economics profession even if a narrow perspective dominated macroeconomics. Economists are already at work to alter the assumptions in their models that have been linked directly to the financial crisis. (This is no guarantee that altering these assumptions will prevent future crises.)
On the other hand, virtually all academic economists are “specialized” in one or another compartmentalized sub-discipline of economics. It would probably take a generation before academic programs produce and reward “Renaissance” academic economists. It will also take years (a generation?) for the degree of academic disengagement “from the real world” to be reduced significantly.
However, Rajan also ignores the fact that academic and professional economists (his distinction) share many of the same problems. “The difficulties of forecasting” exist for both academic and professional economists. This is important given the existence of lags in the policy process. In a book titled “Beyond Mechanical Markets: Asset Price Swings, Risk and the Role of the State”, Frydman and Goldberg address some of difficulties beyond those raised by acknowledging the short-comings of models that incorporate “rational expectations”. They address difficulties inherent in economic modeling and forecasting in general. Some of the salient findings have been cited in reviews and blog posts (see here and here). Quoting from one of the reviews:
Frydman and Goldberg’s thesis deals with more fundamental macroeconomic matters: To what extent can we predict the future? Is there a mechanical causal link that we can ever truly identify and quantify between past and future? They gather and deploy their intellectual confederates: Frank Knight, John Maynard Keynes, Friedrich Hayek, Karl Popper. They argue that rational expectations is one method, certainly a ubiquitous one, based on what they call a “fully predetermined model,” in which market players act as robots and markets operate as a kind of machine; another predetermined approach, they argue, is the New Keynesian school, that is the formalization into mathematical models of Keynes’ “General Theory” of 1936; a third includes some of the more mechanical tendencies of the behavioral school. “To portray individuals as robots and markets as machines,” they write, “contemporary economists must select one overarching rule that relates asset prices and risk to a set of fundamental factors such as corporate earnings, interest rates and overall economic activity, in all time periods. Only then can participants’ decision-making process ‘be put on a computer and run.
(The book) … marshals a powerful argument that’s bolstered by empirical reality: the eternal failures of mechanical forecasting; the sheer difficulty of beating the market with consistency; the unforeseeable ways that history unfolds. The belief in precise prediction resembles a kind of utopian project, a tower of economic Babel. … They quote Popper: “Quite apart from the fact that we do not know the future, the future is objectively not fixed. The future is open: objectively opened…
…. the insurrection Frydman and Goldberg argue for is far greater than just an overthrow of rational expectations; it’s an entire economic world view that claims the power to accurately predict, forecast and capture market reality …
The perspectives of Rajan and the F&G book have implications not only for financial markets, economics, and economic forecasting, but for economic policy beyond its interaction with asset prices. Model-driven financial and economic activities do not always produce the expected outcome. Firms will not always maximize profit streams and policymakers will fail to minimize the “misery index”. On the private side, think LTCM. On the policy side, policymakers did not plan or expect the inflation of the 1970s. The current set of policymakers did not expect the crisis or the great recession, but it is clear that policy through omission, commission or both contributed to this less than positive outcome.
The F&G perspective calls attention to the fact that there is risk attached to policy, especially during periods dominated by non-routine changes, e.g. globalization and rapid financial innovation. The inherent risks attached to policy, in turn, imply that while the Fed’s mandate to hit targets for inflation and unemployment makes wonderful sense politically, pursuing it will at times contribute to inferior outcomes. Notwithstanding all the false precision attached to forecasts and estimates e.g. the existence of the great moderation and the equivalence of $600B of QEII with exactly 75 basis points of reductions in the Fed funds rate.
The risks in policy and the possible costs associated with policy errors suggest that policymakers should not behave as if their model-driven decisions will invariably produce optimal outcomes. Policymakers should be more open than they have been to evidence that indicates that the chosen policy stance is inconsistent with sustainable growth and price stability. Given the specialization in the economics profession as well as evidence that economists or at least economists in macro-economic area are subject to “group think”, the policy process must include individuals who think outside the current box and can see when the reigning model omits non-routine developments which may play a crucial role in driving outcomes.
Economic policy is too important to be left economists who do not appreciate the limitations of economic models. If you think that being a professional economist is necessary to be a good policymaker ask yourself: Whom do you think history will look on more favorably the non-economist Volcker or one of the academic/professional economist Burns, Greenspan or Bernanke?