Stupid After the Event
We're all wise after the event.
The public would have like it better if more of us had been wise before the event. The bankers that are sorry now didn't see it coming. The politicians and regulators won't say they are sorry, but they didn't see it coming either. Who else should have seen it coming? Anatole Kaletsky (in The Times, Feb. 5, 2009) says that economists should join the others in the dock; they are "the forgotten guilty men." By economists, he adds,
I do not mean the talking heads (myself included) employed by the media and financial institutions to “explain”, usually after the event, why share prices or currencies have gone up or down. Nor do I mean the forecasters whose computers churn out scientific-looking numbers about what will happen to growth or inflation, but whose figures are revised so drastically whenever something “unexpected” happens - as it always does - that their forecasts are really nothing more than backward-looking descriptions of recent events.
What I mean by “economists” are the academic theorists who win Nobel prizes, or dream of winning them.
Why economists? The financial crisis, Kaletsky notes, was caused by practical men, not academic scribblers. But Keynes wrote, as Kaletsky reminds us:
Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.
This seems harsh to me. Not all economists were stupid before the event. I'm not well enough connected to have conducted a census, but Robert Shiller was writing about irrational exuberance in financial markets ten years ago. In 2002 my colleague Andrew Oswald predicted the great UK house price crash of 2003 to 2005. (If only he'd been right; we would all be hurting a lot less now.) In the same year other colleagues past and present – Marcus Miller, Lei Zhang, and Paul Weller – warned in the Economic Journal of the "Greenspan put," a "one-sided intervention policy on the part of the Federal Reserve which leads investors into the erroneous belief that they are insured against downside risk." Yes, some were wise before the event. They are people I can only bow to.
What about Kaletsky himself? Two years ago, on March 9, 2007, Kaletsky gave the Colliers CRE annual economist briefing. This is just some of what he said:
Kaletsky firmly believes that there is 'good news' supporting long-term trend growth in the global economy ... A 'mid-cycle slowdown', rather than a recession, is now overdue ... Kaletsky believes that we will experience a slowdown rather than an outright recession. This means we will not see a sharp rise in unemployment and bankruptcies ... The US housing market has undergone a strong slowdown ... Kaletsky is confident that we are much more likely to see a soft landing in the US housing market than a collapse ... Kaletsky firmly believes new home sales have reached a bottom in the US and is confident that 2007 will see signs of a pickup ... The UK will stand out against the tide of slowing growth in Europe ... the financial sector - led by London - will go from strength to strength ... Although a number of commentators have focused on the risks of a house price crash, Kaletsky believes these to be overstated.
In January 2008 I attended an AEA panel in New Orleans where Shiller, along with Paul Krugman and Nouriel Rubini, academic scribblers all, acurately predicted the coming huge bust in the U.S. housing market. A month later, on February 5, 2008, Kaletsky told Colliers CRE:
We are approaching the end of the credit crisis in terms of time, if not necessarily pricing, and that it will be resolved one way or another in the next month ... The US is experiencing its worst economic downturn since the 1990s, but Kaletsky believes the worst may be over, although the risk of recession remains.
Of course, Kaletsky said a lot more than I have quoted, and I have quoted very selectively. If you prefer to read the full texts of his briefings, they are both here. Let me add that, in his 2008 remarks, Kaletsky made one other very important point:
in 2005, the International Monetary Fund (IMF) conducted a study of recessions around the world. Of the 74 recessions studied, only four were predicted in the preceding year. Furthermore, only one third of forecasters interviewed in a recession year actually spotted the recession in that same year.
So what? Here's what.
Nearly everyone has been wise after the event, not before. Don't get me wrong: being wise after the event is very important; let's not undervalue it. Being wise before the event is best, but being wise after the event is the next best thing. And being wise after the event definitely dominates being stupid after the event. This is a danger that I'll come to.
If we want to be wise after the event, it's time to rethink. What are the parts of economics that need rethinking? According to Kaletsky it is our concepts of
the “efficiency” of markets and the “rationality” of the investors, consumers and businesses who inhabit them.
I agree! We should rethink the way we use the rationality assumption. As an economic historian, I use it in all sorts of peculiar context. I have argued (here for example ) that the value of the axiom lies partly in helping us draw a line between what we do and do not understand. If we assume that individuals behave with full rationality, subject to constraints, and our models works in terms of simulation or prediction, then we can at least kid ourselves that we have understood that behaviour in the sense that we don't need anything more complicated to analyse it. If the model doesn't work, it tells us we failed to grasp something – some constraint on behaviour or some bound on rationality – that is missing from our model. In short, the rationality assumption helps us draw a line between what we understand and what we don't.
Recent events are shifting that line, but in different ways for different people. First is a relatively narrow group, those (not all) financial economists that bought heavily into the efficient markets hypothesis and rational expectations; they have seen their frontier with the unexplained collapse inwards. Second are a much wider group, the macroeconomists that did not buy the efficient markets hypothesis, but nonetheless believed that in the event of market failure governments had the power, the monetary and fiscal instruments, the capacity for international coordination through G8, G20, IMF, and so forth, and the will to avert the worst consequences. We are watching events unfold, but I am much more pessimistic than I was.
The main problem for economics that I see is this. Most professional economists are clever people. Clever people have one weakness: they are clever in many ways. One of these is getting at the truth. Another is being contrarian. In fact, because they are clever, and often highly motivated, clever people tend to be good at denial. They can think up a thousand sophisticated arguments to defend manifestly absurd ideas. My rule of thumb is that everyone, including me, believes in at least one completely crazy idea; the trouble is, I don't know which one it is. So look out for a lot of clever economists who are going to be stupid after the event, because of some idea they are wedded to and will continue to defend while the world walks off in the other direction.
If I'm clever enough, I may well be among them.
The main problem for politics is different. It is that it is much more fun to play the blame game than to do something – something for which, in future, you may be blamed. As a result, politicians and journalists in our country (and no doubt elsewhere) are now sitting around throwing accusations at bankers, economists, journalists, and each other – particularly at bankers, which is fine in a way because monetary policy can currently do nothing more to make things better, so why not?
Except that it is a diversion from the one thing that can now make things better, the promised fiscal stimulus. We are losing 100,000 jobs a month – and unemployment is a lagging indicator. To make a difference, the fiscal stimulus was needed six months ago. It seems that we cannot even count on the automatic stabilizers that should limit recession. While local authorities lose revenue, for example, councils are cutting jobs and services that they can no longer afford but the community needs ever more desparately. The current lack of fiscal action on the part of our government is scandalous. Stupid after the event.