Wednesday, December 24, 2008

Economists missed the brewing crisis

This article was brought to my attention by my colleague John L. Tomkinson (History and TOK) and I thank him as it is very interesting for all of us doing IB Economics and even more so for those planning to major in Economics somewhere in the UK or the US.

The full title of the article is: Paradigm lost: Economists missed the brewing crisis. Now many are asking: How can we do better? It starts by noticing that everyone is baffled by how the current crisis started and was transmitted throughout markets and economies:
The vast majority of us, after all, are not experts. But academic economists are. And with very few exceptions, they did not predict the crisis, either. Some warned of a housing bubble, but almost none foresaw the resulting cataclysm. An entire field of experts dedicated to studying the behavior of markets failed to anticipate what may prove to be the biggest economic collapse of our lifetime. And, now that we're in the middle of it, many frankly admit that they're not sure how to prevent things from getting worse.
The whole article is thought provoking but, if you aren't about to read the whole thing here then, at least read this, as it should sound familiar:
Already, the crisis is reshaping long-running debates. It has chastened believers in the self-correcting abilities of the free market - Alan Greenspan said as much before Congress in October - and emboldened those who see the need for more active government intervention.

In a sense, it's a debate that has been seesawing back and forth from crisis to crisis over the past century. Classical economics was devastated by the Great Depression, and in the years afterward gave way to the ideas of the British economist John Maynard Keynes: that individually rational economic decisions could add up to collectively disastrous consequences, that the "stickiness" of prices and wages could lead to long-term unemployment and stagnation, and that the government, as a result, has to step in to kick-start the economy.

The stagflation of the 1970s, while mild compared with the Depression, swung the pendulum back. It was Milton Friedman, a sharp critic of Keynesianism and a fervent advocate of unfettered free markets, who solved the seeming paradox of simultaneous inflation and high unemployment by realizing the deadening power of people's expectation of future inflation, and it was Friedman's proposed solution - sharply restricting the money supply - that eventually, albeit painfully, solved the problem.

Today's crisis has brought Keynes back to the center of the discussion, but some economists also see it driving the field into new territory. Up until very recently, the study of market bubbles was marginalized - there was no widely accepted definition of what a bubble was, and some economists, believers in the complete rationality of markets, argued that bubbles didn't even exist. Today, however, there is a growing sense that understanding bubbles is vital to understanding markets - among those making the case is Federal Reserve chairman Ben Bernanke, who, as head of the Princeton economics department, made a point of hiring young economists interested in the topic.

Over the same time period, the field of so-called behavioral economics has risen to prominence, led by, among others, Thaler, Laibson, and Robert Shiller, a Yale economist who warned of both the housing bubble and, in 2000, the dot-com bubble. By borrowing the insights and methods of psychology, behavioral economics focuses on all the ways in which humans fail to act as the rational, self-interested beings that economic models call for - we aren't good at thinking about the future, we're susceptible to peer pressure, we overestimate our abilities and underrate the odds of bad things happening. It's a set of traits that describes perfectly the behavior of many of the people who, in a cascade of self-defeating decisions, helped create the subprime crisis.
Thanks, John.

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