Predicting the Crisis

Apparently the Queen of England recently asked an economist why the economics profession failed to predict the financial crisis. Gavyn Davies responds that the explanation is this: it's simply very difficult to predict such rare and massively disruptive events.

Calculated Risk wrote about the same subject the other day, noting that there were a number of informed and smart individuals (including but not limited to economists) who predicted the crisis, but lamenting that warnings by "some random blogger[s]" were ignored or not taken seriously.

Davies and CR both have good points. Yes, it bears remembering that there were plenty of people out there who explicitly warned of the financial crisis. (As CR notes, there are so many examples to chose from, but I'll pick a couple of my own personal favorites.) So the Queen's premise - and that of lots of people who have asked the very same question over the past couple of years - is faulty. It's simply not the case that the "economics profession" failed to predict the crisis.

And yet. And yet it's also true that those economists with the most prominent positions in Washington and Wall Street - let's call them the "establishment economists" - did, by and large, fail to predict the crisis. Which tells me that something else was going on other than just the fact that it was difficult to do. It seems an unlikely coincidence that most establishment economists missed the crisis while many of those outside of the establishment could see it coming.

To me, this unlikely coincidence suggests that part of the explanation is something else: it was actually in the interest of establishment economists to fail to predict the crisis. When the financial markets are roaring, and Wall Street bonus checks are fat with the earnings from the housing bubble, announcing that the big firms should stop doing what they're doing to make all of that money is probably not the smartest career move. Rather, an economist would probably have done better (establishment career-wise) if their analysis happened to confirm and provide analytical support for the activities that were making so many firms so much money during the run-up to the crisis. This could well have lead to a type of selection bias: establishment economists were in their establishment positions precisely because they were the ones that could reassure and support the money-making activities of the firms profiting from the frothy financial markets.

I'm not saying that these economists were venal or corrupt. And I don't think that there was intentional dishonesty in the cheerful forecasts and palliative words from establishment economists in 2005-07. But I do think that it's important to remember that it wasn't a coincidence that establishment economists were so good at telling Wall Street that there was no reason to end the party.