Tuesday, August 18, 2009

In defence of economists

Morale in the economics profession is rather low, given the panning that economists have received in the wake of the sub-prime crisis. People have asked: how come economists did not provide warnings or don't seem to have solutions? (although some did warn and many have proposed solutions). The Economist ran a cover story in July about all that went wrong with the economics profession.

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.

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 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.

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.


Anonymous said...

Just two about Robert lucas response to criticisms against economists.

1. The criticism, AFAIK, is not against macro economics in general. It is against the methods of neo classical economics. And the criticism comes not from outside, but from economists of other traditions like Austrian, cambridge based post-autistic etc. (and even the socialists and marxists ..maybe for different reasons)

2. If one accepts Lucas' arguments, it would become problematic to explain how many economists and finance guys including Roubini, peter schiff and others could actually warn about the coming crisis much in advance and that too with clear explanation on the phenomenon. My point is, if one understands the mechanics of business cycles as explained by Austrians, it is quite evident that a crisis was coming. Only the neo-classical guys found it difficult to understand.

3. The argument on factoring in policy response in modeling is quite astonishing. Are you suggesting that the models wanted to institutionalize "socializing the loss and privatising the gain" concept. Kind of saying .. Oh bankers of the world.. use any silly risk management model.. use any credit rating model.. dont worry about results. we are here to help you out in case you lose.

Prof. Rammohan, i would like to hear your thoughts on these points

Naveen Bangalore

T T Ram Mohan said...


1. Whether one likes it or not, there is such a thing as 'too big to fail'. If this policy has been practised in the past, models would duly incorporate it. Hence, the absence of such a response and the economy's free fall would not be predicted by the model.

2. As for Roubini and others warning about the crisis, talk about macro-economic imbalances had been on for at least five years. The world economy boomed regardless. If you say it's going to rain, you will be proved right at some point over five years. There is also the issue of whether the crisis would have been as severe if regulations had been a little tighter. Would macroeconomic forecasters like Roubini have been right then about the severity of the downturn?


Anonymous said...

1. Giving legitimacy for " too big to fail" concept only helps the entremched big players (who oftern play foolishly) at the cost of small innovative banks who plays prudently. Even Stiglitz argues that allowing failed banks to go to the wall would have been far healthier in the long run.

2. Whether it is roubini , Peter schif, Ron Paul etc.. all of them dint just say that a rain is coming. They said why it is coming, why it would defenitely come and when it is likely to come. Please dont take credit from them Look at this samll video.

Naveen Bangalore

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