Most Economists Understand Neither The Cause of Nor The Solution To The Financial Crisis → Washingtons Blog
Most Economists Understand Neither The Cause of Nor The Solution To The Financial Crisis - Washingtons Blog

Thursday, December 25, 2008

Most Economists Understand Neither The Cause of Nor The Solution To The Financial Crisis

As many writers have tried to point out, mainstream economists understand neither the cause of nor the solution to the financial crisis.

As an article this week in the Boston Globe notes:

Many [economists] frankly admit that they are not sure how to prevent things from getting worse.***

"Everyone that I know in economics, and particularly in the worlds of academic finance and academic macroeconomics, is going back to the drawing board," said David Laibson, a Harvard economist. "There are very, very, very few economists who can be proud."

A few suggest, as well, that there are deeper problems in the discipline. U.S. economists are asking aloud whether the field has grown too specialized, too abstract and too divorced from the way real-world economies actually function. They argue that many models used to predict the dynamics of financial markets or national economies have been scrubbed clean, in the interest of theoretical elegance, of the inevitable erraticism of human behavior.

As a result, the analytical tools of the trade offer little help in a crisis and have little to say about the sort of collapses that led to this one.

"You can't just say, 'I have a model for tremors that works great - I just can't explain earthquakes,"' said Kenneth Rogoff, an economist at Harvard who has studied financial crises.***

The models used by macroeconomists do a poor job of describing the messiness of an actual market in flux.

As a result, economists end up oversimplifying such situations when they model them - or simply avoid studying them at all.

"We have a very restrictive set of language and tools, and we tend to work on the problems that are easily addressed with those tools," said Jeremy Stein, a financial economist at Harvard. "Sometimes that means we focus on silly questions and ignore greater ones."

Derivatives is a prime example of what economists totally missed.

The mathematical models predicted that the entire financial system would be stabilized by derivatives. But the models did not account for anything going wrong like - oh, I don't know - home prices going down, hedge fund asset values declining, or currency or interest rate relations substantially changing.

Will Obama straighten things out?

Well, as the above-quoted Boston Globe article notes:

For years, leading economic figures like Lawrence Summers and Alan Greenspan argued that the United States had more or less brought the business cycle to heel.

Summers is a key Obama economic advisor.

And most of Obama's advisors have profited handsomely from derivatives and other toxic investments. So they are not likely to challenge the status quo.

Unfortunately, economists - no less than lawyers, scientists, and just about every other class of professionals in the U.S. - have sold their soul to the powers-that-be.

8 comments:

  1. MODEL, MODEL , MODEL

    More math won't solve the problem. A sure sign we are headed for trouble when you here words like during the dot com bubble you heard time after time "THE OLD RULES DON'T APPLY"

    and now we here "For years, leading economic figures like Lawrence Summers and Alan Greenspan argued that the United States had more or less brought the business cycle to heel.

    These kind of words should be a red flag for anyone serious about this economy. Basic rules don't change.

    I call it "CHECKBOOK ECONOMICS" and have posted various comments on my blog http://thegreytiger.wordpress.com/

    When economists say they didn't see the mortgage crisis coming they had to be either blind or stupid. I remember years ago when I started building my first house the rule was you could borrow 2.5 times your annual salary max. Many an argument was had over could we even afford that. These dudes were lending 10 time annual earnings and didn't see a problem in that! PULEEEZE.

    Citibank leveraged at 100:1 when 12:1 was the ancient standard.

    Rating companies waving their AAA wand on the junk they were slicing and dicing. I have some very good buy on bridges, Interested??

    Derivatives? A whole different story. Bets on bets on bets that the sun will shine on Jan 5 except in Iowa. This was a market stabilizer. The old argument that this kind of thingy was good for farmers for instance , go talk to a farmer now and see how he feels.

    The corruption and or stupidity the last 30 years only has it's equal in the 20's.

    ReplyDelete
  2. Models are great at modeling modelers' assumptions. But, as GW points out, how these assumptions interface with reality is a whole 'nother ballgame - and one with far fewer and laxer rules. It's like the difference between practicing meteorologists and academic 'climate change' modelers. In general, the former uses data, and the latter makes data.

    ReplyDelete
  3. Call a special session of Congress to rewrite the mortgage contracts into something that conforms with predatory lending laws.

    This will...

    1. Allow the homeowners to keep their homes and continue making reasonable mortgage payments.

    2. Said mortgage payments will strengthen the Mortgage Bond Securities that have eaten Black Holes into the balance sheets of the Banks.

    3. Said Banks with strengthened balance sheets will then go from negative net worth back into the black and be able to lend again.

    4. Said lending will restart the Economy.

    ReplyDelete
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    ReplyDelete
  7. The Austrians knew!!

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