17 Aug 2009

More Thoughts on Economists Making Excuses

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I’ve been really disappointed in economists taking the Robert Lucas / Bill Easterly approach in answering the Queen of England’s perfectly good question, “Why didn’t you economists see the financial crisis coming?”

To refresh your memory, here is what Easterly (a big-name economist at NYU who has done some cool work on development) said:

First, Your Majesty, economists did something even better than predict the crisis. We correctly predicted that we would not be able to predict it. The most important part of the much-maligned Efficient Markets Hypothesis (EMH) is that nobody can systematically beat the stock market. Which implies nobody can predict a market crash, because if you could, then you would obviously beat the market.

In other posts, I have pointed out that this reasoning is only true if you frame investing the way an economist using a rational expectations model would frame it. It’s analogous to game theorists concluding that the only “rationalizable” strategy is to immediately defect in a 3000-round prisoner’s dilemma, even though “irrational” players in the real world will end up making a lot more money following their ad hoc strategies.

But in this post, let’s take Easterly’s response at face value. The Queen could and should come back and say:

Yes, gentlemen, very well. So I’m asking you, why didn’t you forecast these things back in 2004, so that housing prices would have popped back then? You wouldn’t have beaten the market; you would have spared the market trillions in losses.

Everyone with me? If you’re still not seeing it, let’s switch examples. Let’s suppose that George Bush was taken utterly surprise by the attacks on 9/11. (I realize there are some who would dispute that, but go with me on this–I’m just making a point.) Bush is furious and calls in all the intelligence gurus. He takes them out to the woodshed, demanding to know why they get funded billions per year if they can’t even see an attack on US soil coming that takes out the Twin Towers and hits the Pentagon, for crying out loud!!

Now can you imagine if somebody said, “Well Mr. President, we all feel awful about this, but it really wasn’t our fault. By its very nature, an attack like 9/11 couldn’t have been forecasted. If any of us had predicted it–even as late as 9/10–then we would have foiled the plot–we’re all patriots, after all.”

Now wouldn’t the above excuse have been worthy of an Atomic Wedgie? Well that’s what Easterly said to the Queen. But by dressing it up with fancy terms like “efficient market hypothesis” Easterly’s answer sounds deep, rather than patently absurd as the above quote is.

One last way of putting it, to make sure you get my point here: If the gurus on CNBC and in the bowels of the ratings agencies had realized how fragile things were in, say, 2005, then history would have been averted. Things wouldn’t have gotten even more fragile in 2006. So in the alternate universe, it’s not the case that the housing bubble still would have been just as severe, except that Bill Easterly made billions shorting the market. No, the bubble wouldn’t have been pumped up as much.

In that alternative universe, it still would have been true that “no one beats the market” (in the tautologous sense that Chicago School economists use that incantation). But “the market” wouldn’t have lost trillions of dollars.

The mainstream economists screwed up big time during the housing bubble years. The people interviewed on CNBC, and advising the government, weren’t saying, “What are you coming to us for? We have no special insight on the stock market.” No, they were assuring investors that the boom would last. (And I regret to say that I contributed to this madness before seeing the light [.pdf] in the summer of 2007.)

Lucas and Easterly are saying nothing more profound than, “It’s true we economists didn’t predict the crash, but then again neither did most of the big-money people around the world.” This is true, and the Queen’s correct response should be, “Fine, so my question is, why not? What did you–and most of the rich people–do wrong, so that we can try to prevent this from happening again?”

People were already suspicious of economists before this crisis. Now it’s downright embarrassing.

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