Robert Lucas responds to the criticism about why models failed to predict the depth of the downturn:
The Economist’s briefing also cited as an example of macroeconomic failure the “reassuring” simulations that Frederic Mishkin, then a governor of the Federal Reserve, presented in the summer of 2007. The charge is that the Fed’s FRB/US forecasting model failed to predict the events of September 2008. Yet the simulations were not presented as assurance that no crisis would occur, but as a forecast of what could be expected conditional on a crisis not occurring.Lucas is right, of course. Models do incorporate policy responses. Few economists would have thought that the US government would let a big bank fail. Such a failure would not have been part of the model. The decision to let Lehman was an inexplicable blunder- and it is doubtful that the crisis would have been as severe if that had not been allowed to happen.
Until the Lehman failure the recession was pretty typical of the modest downturns of the post-war period. There was a recession under way, led by the decline in housing construction. Mr Mishkin’s forecast was a reasonable estimate of what would have followed if the housing decline had continued to be the only or the main factor involved in the economic downturn. After the Lehman bankruptcy, too, models very like the one Mr Mishkin had used, combined with new information, gave what turned out to be very accurate estimates of the private-spending reductions that ensued over the next two quarters. When Ben Bernanke, the chairman of the Fed, warned Hank Paulson, the then treasury secretary, of the economic danger facing America immediately after Lehman’s failure, he knew what he was talking about.
Lucas also points out that the policy response to the crisis, based on whatever economics has taught us about crises in the past, has been pretty effective at least ensuring that there is no repeat of the Great Depression:
The recession is now under control and no responsible forecasters see anything remotely like the 1929-33 contraction in America on the horizon. This outcome did not have to happen, but it did.