Why Economists Missed the Crises

Why did Economists, as a group, miss the warning signs of housing, credit and market crisis?

I don’t mean individuals — several professional Economists got it right; Academics like Nouriel Roubini of NYU and Robert Shiller of Yale, as well as a few Wall Streeters, such as David Rosenberg of Merrill Lynch and Paul Kasriel of Northern Trust. Too many bloggers to name also got it right. Meanwhile, the vast majority of professional economists, strategists and analysts — the “Herd” — totally missed it.

One explanation comes from Dean Baker, who channels Keynes, and says “incentives in the economics profession, just as in finance, strongly encourage a lack of original thinking.” (That’s a variation of Keynes: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally“). Paul Krugman wondered if it was a fear of going “against bubble denier Alan Greenspan.”

I find all these explanations wanting — and quite frankly, too generous by half.

My explanation is there were systemic failures in economics as a discipline, at least as it is employed in the real world. Note that these are not theoretical critiques (i.e., Keynesians versus Monetarists), but rather, these are broader inquiries as to why so many working economists were so utterly clueless about all of the red flags for so long. The inherent biases of working on Wall Street go along to explain why those economists were so awful — but I have less of an explanation as to why so many academic economists were so blind. Perhaps it is the profession itself.

As far as Central Bankers were concerned, they too missed the warning signs — but there were several notable exceptions to this to, including the Bank of England’s concerns about a credit crunch and a collapse in asset prices.

Ideas? I have a few. Here are my top 10 indictments as to why professional economists missed the crises until it was too late:

1. An inherent upward bias is built into ALL Wall Street research — including economic research;

2. Ideological rigidity prevented creative thinking;

3. Non-critical acceptance of official data from BEA, BLS, Commerce led to only a passing familiarity with reality;

4. Institutional rejection of negative analyses remains endemic;

5. Traditional (non-behavioral) economic analysis seems to have difficulty with human irrationality;

6. Political Bias; (Right wing during GOP Presidencies; Left Wing during DEM Presidencies);

7. Corporate bias — Stock option compensation — skewed views too optimistic;

8. “Timing” is very different from Analysis;

9. Factoring in excessive leverage and liquidity is exceedingly difficult from a traditional economic perspective (Derivatives especially);

10. Herding instinct is powerful;

Economics as a discipline does not seem to be particularly introspective. In my opinion, the sooner the profession develops some self doubt, recognizes its own failings and shortcomings, the faster they will be able to recognize the failing constructs of the profession and fix them. The Efficient Market Hypothesis, homo economicus, the deification of markets, all need an open public review and a good thrashing.

There were many professions that did not distinguish themselves in the lead up to the housing boom and bust, financial bust, the credit crisis, and the recession. Economics is near the very top of that list.

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Previously:
The Mystery of the Awful Economists
Barry Ritholtz
RealMoney.com, 3/2/2005 3:42 PM EST
http://www.thestreet.com/p/_rms/rmoney/barryritholtz/10211333.html
(Free version at Investors Insight)

Sources:
Bubble blindness
NYT December 23, 2008, 5:16 PM
http://krugman.blogs.nytimes.com/2008/12/23/bubble-blindness/

APPLY ECONOMICS TO ECONOMISTS
Ezra Klein
The American Prospect, December 23, 2008 11:26 AM
http://www.prospect.org/csnc/blogs/ezraklein_archive?month=12&year=2008&base_name=apply_economics_to_economists

Previously:

Mystery of the Awful Economists, part II (April 8th, 2005)
http://www.ritholtz.com/blog/2005/04/mystery-of-the-awful-economists-part-2/

Mystery of the Awful Economists (Part III) (April 13th, 2005)
http://www.ritholtz.com/blog/2005/04/mystery-of-the-awful-economists-part-iii/

More Sources:

‘City faces meltdown if debt crisis hits’
Edmund Conway, Economics Editor
UK Telegraph, 12 Jul 2006
http://www.telegraph.co.uk/finance/2943149/’City-faces-meltdown-if-debt-crisis-hits’.html

Merrill’s Rosenberg Inspired by Farrell in Foreseeing Crash
Carlos Torres
Bloomberg, Dec. 30 2008
http://www.bloomberg.com/apps/news?pid=20601109&sid=a8KK_pGpxqL4&

The Doomsayers Who Got It Right
More Bad News in Store for 2009? Last Year’s Cassandras Are Still Gloomy
JEFF D. OPDYKE
WSJ, JANUARY 2, 2009
http://online.wsj.com/article/SB123086035502948067.html

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