06 January 2011

INET Discussion: Failure of Predicting Global Financial Crisis

In October 2009, with a $50 million pledge by George Soros, the Institute on New Economic Thinking (INET) was founded. Although the stated mission of this institute is not that easy to understand word by word, its aim essentially is a radical reorientation of economic theory. Among others, on INET website there is started a discussion about the question: “Why did so many economists fail to predict the global financial crisis, and so many policymakers mishandle it -- while some saw it all coming?” Further it is explained that economists by and large either failed to anticipate the global financial crisis that began in 2008, or greatly underestimated its severity. The question continues: “What about the economics field led policymakers and practitioners to fail so spectacularly? Will the same problems get in the way again and so undermine the recovery, or worse, lead to a repeat disaster? Or are there alternative theories to analyze the situation and avoid the problems next time?”
Several true statements have been made or referred to by the initiators of the discussion. Just to name a few (besides the failure of the rational-expectations paradigm and efficient market hypothesis plus the other erroneous assumptions underlying economic models):
  • Bad models lead to bad policy: instead of real problems, the focus was on small economic inefficiencies
  • The sight of the bigger picture was frequently lost
  • Everyone (households, businesses, bankers, governments) benefited from the previous period of growth and growing excesses; no one really wanted to see the risks
  • Psychology of herding and the mantra of financial and policy gurus
In a now famous letter in response to a question by Queen Elizabeth, economists and academics in England claim that many people did foresee the crisis; however, the exact form that it would take and the timing of its onset and ferocity were foreseen by nobody. They conclude that the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people to understand the risks to the system as a whole.

I’d say that those analysts and economists who did not see the excesses and risks growing in 2005-2006 where either inexperienced (i.e. did not understand the logic of finance and economy) or did not have the courage to go against mainstream media, which was blinded by great but unsustainable success. It obviously was (and is) the lack of education that our universities provide: the true logic of finance and economy is rarely (if at all) taught to students, probably because if one starts looking into it, it’s so bleak and generates so much unfairness. For those more interested I have described some of the fundamental flaws and issues of the prevailing system in my earlier articles:
Will the disaster repeat? Well, if we continue as we first responded to the crisis with focusing to stricter regulations for financial system and securing that bailout funds are always available for failing governments and systemically important companies (although this helped to gain time), the answer is “yes” as these measures provide temporary relief at best. Clearly, much more fundamental changes are needed – not only into the very basic rules of money and banking, but also into the way of how we measure and target growth and success.

It’s not enough that academics, economists and analysts consider themselves as observers nor is it true (here I refer to George Soros’ theory of reflexivity). No matter how we measure risks, fundamental flaws are still there. The problems described in the above referred articles and all those not described yet make it highly unlikely that we will ever be able to estimate the exact timing of bubbles bursting. So I’d argue that the focus of INET’s question is wrong. Furthermore, the focus of INET currently seems to be misplaced. What’s needed to be done is first to study the fundamental issues (as opposite to the study of what academics and economists did wrong when forecasting economy). Secondly, the focus has to be on real solution: first thinking and then acting accordingly.

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