Uh-Oh: Is Shiller Defending the Failures of Economists?

Was it the hammers or the carpenters?

That is the question alluded to this morning by Yale Professor Robert Shiller in the NYT. Shiller is one of my favorite academics working in the field of finance. He tries to (diplomatically) argue we can prevent future crises if only we had better econometric tools. I would counter that future crises could be avoided if only we had less economists who were fools.

Lets look at what the Professor wrote:

“There were relatively few persuasive warnings during the 1920s that the Great Depression was on its way, and few argued convincingly during the last decade that the most recent economic crisis was near. So it’s easy to conclude that because we didn’t see these events coming, nothing could have been done to prevent them.

In fact, some people view the recent crisis as just another “black swan event,” one of those outliers, as popularized by Nassim Taleb, that come out of the blue. And it’s clear that a lot of smart people simply didn’t see the housing bubble, the instability of our financial sector or the shock that came in 2007 and 2008.”

Uncharacteristically, Professor Shiller is deeply wrong about this. There were numerous “persuasive warnings” and “convincing arguments” prior to the most recent disasters. They were mostly ignored for a variety of cognitive reasons. It was not that they were not understood, it is that most people selectively refused to believe what was against their own interests. When the potential damages of what might occur is too ugly to contemplate, the silly humans find ways to ignore the truth; we seem to prefer comfortable fictions to painful reality.

And while many “smart people” may not have seen the crisis coming, many did. (Perhaps we need to rethink who we call “smart people” in the future).

It is noteworthy that one such smart person, Professor Shiller himself, had convincingly warned about the dot com bubble in 1999 and the housing collapse in 2005. And he did so using readily available data. So if some smart people did see the crisis coming, and made appropriate warnings, perhaps it is not the tools that are at fault?

Back to the Professor:

“But the theory of outlier events doesn’t actually say that they cannot eventually be predicted. Many of them can be, if the right questions are asked and we use new and better data. Hurricanes, for example, were once black-swan events. Now we can forecast their likely formation and path pretty well, enough to significantly reduce the loss of life.

Such predictions are a crucial challenge in economics, too, and they are why data collection need not be a dull or a routine field. If done correctly, it can be very revealing.”

While having better tools to measure the economy is a good thing, it would not have changed a single thing when it came to the crisis. What matters more than those tools and the data collection format are the institutions charged with overseeing the process, and who is actually interpreting that data.

Back in 2009, we discussed these 10 factors Why Economists Missed the Crises:

1. Inherent upward bias is built into ALL Wall Street research (including economics)
2. Ideological rigidity prevented creative thinking;
3. Non-critical acceptance of official data
4. Institutional rejection of negative analyses;
5. Classic Economic analysis seems ignores human irrationality;
6. Political Bias;
7. Compensation skewed views towards excessive optimism;
8. “Timing” is very different from Analysis;
9. Derivatives, leverage, liquidity a difficulty for traditional economics;
10. Herding instinct is powerful;

Hence, it is not the tools but the fools who were at fault. Even if we had better data — a social good we all should enthusiastically support — it would not have mattered.

Few economists have had more insight into various aspects of behavioral finance than Professor Shiller. His work has been hugely influential in getting more people to see how human cognitive failures lead to significant errors. But it also explains why the data was not what was not the problem.

The fault, dear Professor, is not in our stars, but in ourselves.


Why Economists Missed the Crises (January 5th, 2009)

Needed: A Clearer Crystal Ball
NYT, May 1, 2011  

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