The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at www.cumber.com. He may be reached at Bob.Eisenbeis@cumber.com.
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It has become fashionable for commentators to bash economists for having missed the financial crisis of 2007-2009. Nobel Prize winner Robert Lucas provided a recent rebuttal to critics in a guest article in The Economist of August 6, 2009. Unfortunately, it was a rather unconvincing effort.

More recently, Nobel laureate Paul Krugman, in his NY Times article of September 2, 2009 entitled “How Did Economists Get It So Wrong?” took his own shots at the profession. He essentially repeats two criticisms that were addressed in Lucas’ article. The first is the profession’s fixation on elegant mathematical models, and the second is its belief in efficient markets – the idea that market participants use all available information when making economic decisions and pricing securities. He claims that in the world of theory – which many economists tend to believe is the “real” world – markets are inherently stable and do not admit the possibility of “catastrophic failures in a market economy” like the current crisis. Should a problem occur then it could be easily corrected by appropriately administered Federal Reserve policy. Are these criticisms well-deserved and are they directed at the right people?

Krugman’s critique has brought forth a host of rebuttals from academic economists who defended their performance. Still, one has to concede that Krugman has some valid points. The first concerns the bias among theorists for stability and stationarity in their models. Models serve a useful purpose in all fields of physical and social science. In economics, the trend has been toward building models that exhibit stationarity and stability, so that they tend toward a fixed long-run equilibrium and naturally return to that equilibrium if shocked. Publish these types of models and you will advance your academic career. There has been relatively little interest in the contemporary academic profession in market imperfections or in models that may admit such properties.

However, what critics also fail to recognize is that academic economists are not engaged in the same activity as business and policy economists. Academics are not building forecasting and prediction models of the kind the critics seem to be demanding or expecting. Academic economists are mostly unconcerned and largely uninformed about the week-to-week data releases or the policy moves that the Federal Reserve makes and that fill time on CNBC, Fox Business, and Bloomberg TV. In fact, academia puts little value on forecasting. Once you have built a forecasting model, there is nothing more to be gained intellectually from the academician’s perspective by running the model week by week as new data becomes available. This is really the province of the Federal Reserve and other government agencies, economic consultants, the business economists that populate Wall Street and large corporations who have to make business and policy decisions based upon the outcomes of those forecasts.

The more relevant question, if one wants to criticize the profession, is to ask what the policy economists and forecasters were seeing and saying. If any group should have seen the crisis coming, for example, it was the economists at the Federal Reserve. After all there are a lot of them and they have the most sophisticated, large economic forecasting models that exist. What did they see? When did they see it? If they didn’t see it, why not?

Although Krugman criticized former Federal Reserve Governor Rick Mishkin for some of the benign projections he had presented based upon the Fed’s large scale model shortly before the crisis broke, one would not realistically expect a sitting Federal Reserve governor to be suggesting publicly that the economy or financial markets were about to collapse. As Lucas argues, Mishkin was talking about the likely paths for the economy, conditional on a crisis not occurring. We also need to recognize that forecasting and prediction models are only as good as the inputs and structure of the economy that the models capture. Unfortunately, existing models have been constructed without data from periods of economic downturn and severe crises, similar to what we have recently experienced. To expect that models would provide the kinds of precise out-of-sample forecasts the critics seem to be demanding is unrealistic. We will have to wait for the release of the FOMC Greenbooks and Bluebooks to get a better sense of the issues and what the inside view was of the crisis as it unfolded. Then, the second guessing will be more fruitful.

One of Krugman’s other explanations for the failure to correctly predict the crisis has to do with economists’ assumptions about human behavior and, specifically, that markets are efficient and people respond rationally to events. Instead, he suggests that in the future economists will have to deal with a messier world – one now inhabited by those interested in so-called behavioral economics and finance. This world is one that has concentrated mainly on demonstrating that people don’t always act rationally in making economic decisions. However, Charles Kindelberger, in his classic book, Manias, Panics, and Crashes: A History of Financial Crises, sets out four alternative definitions of rationality, each with different implications for model structure. Some of these concepts are not inconsistent with the observed supposed deviations from rational behavior that have preoccupied the behavioral economists. Putting Krugman’s objections to the side for a moment, there are other ways of thinking about this problem and whether the assumption of rationality is truly a flawed basis for structuring models.

First, I was always taught that economics and finance were the study of human and firm behavior and decision making. If this is not the case, and only “behavioral economics and finance” are focused on “real decision making,” then it isn’t clear what nonbehavioral (or regular) economics and finance have been studying for all these years.

Second, proponents of so-called behavioral finance have yet to offer significant theories that systematically describe human behavior or that yield better predictions than current approaches. Simply demonstrating that a particular set of assumptions doesn’t always hold, is not a substitute for a new theory, nor does it provide the basis for a new discipline. Put another way, in science and social science, it takes a better theory (model) to beat an accepted theory (model). If it is not possible to put forward an alternative, which behavioral finance and economic theorists have not yet done so, then proponents of behavioral finance and behavioral economics are effectively suggesting that human behavior is random and/or irrational. This means that it may not be possible to build a systematic theory to describe nonrational decision making. It implies that the fields of economics and finance may not be legitimate fields of study – leaving only the field of abnormal psychology.

Third, as mentioned previously, it is not true that economists failed to predict that a crisis or significant market adjustment was approaching. Many in the profession correctly foresaw that trouble was brewing in the mortgage market because they saw the perverse effects that subsidies and government interference were having on the effective functioning of markets. Chairman Greenspan warned about the risks, for example, that Freddie and Fannie posed, long before their collapse. Economists have also demonstrated that government subsidy policies designed to indirectly support housing in the ’60s and ’70s were at the heart of the S&L crisis. Perverse subsidies reared their heads again through the actions of Freddie and Fannie and related governmental housing-support activities that were at the heart of the explosive expansion of the housing market and the run-up of real estate prices. Again, these issues have been pointed out time and time again. To be sure, the exact timing of the crisis was not pinpointed, but certainly many micro and regulatory economists saw the problem. This includes not only many of us at the Fed who published warnings on the issues, but also members of the Shadow Financial Regulatory Committee, and many others as well.

Fourth, there is an alternative and more plausible explanation for the crisis other than it flowed from presumed irrational behavior on the part of market participants. Building on the previous point, government policies have long combined to create a substantial set of incentives for rational people to invest in real estate and to take on mortgage debt. Mortgage debt and local real estate taxes are tax-deductible, which encourages leverage and lowers the relative cost of mortgage debt (and, hence, home ownership). Interest rates were held extremely low coming out of the 2001 recession, and mortgage rates were at historically low levels for several years. Both the Clinton and Bush administrations had the encouragement of home ownership as a key policy objective. Congress created Freddie and Fannie and continually encouraged them to expand their portfolios and to invest and support “affordable housing” for low- and moderate-income people. Freddie and Fannie were forced to expand significantly their portfolios of subprime loans. HUD set goals in 2000 that envisioned 50% of the dwelling units financed by Freddie and Fannie would be for low- and moderate-income families. Furthermore, at least 20 percent would be for “very low-income families.” Freddie and Fannie traded on the market perception that they were the beneficiaries of government guarantees should they get into financial difficulties. This enabled them to leverage themselves to dangerous levels, and when they collapsed the implicit guarantees were in fact honored. The Community Reinvestment Act encouraged banks to channel funds into low- and moderate-income areas, and regulators lowered capital requirements on mortgage loans compared with other loans. Even if borrowers found themselves unable to meet their mortgage payments, relaxation in the bankruptcy statutes made it more accommodative for borrowers to declare bankruptcy and walk away from their mortgage debts. It has been argued that those who got into mortgages they couldn’t afford did so rationally. Why? Because even if they were forced to default, in the short run their cost of living (i.e., housing) was lower than it would have been had they simply rented.

In summary, where do we stand when it comes to criticism of the economics profession? Once one recognizes that the academic side of the profession is not primarily engaged in activities designed to either identify or predict recessions, depressions, or economic collapse, it is understandable that these economists would be defensive. Whether the profession is focusing on the right questions or whether its approach to modeling is correct or useful is another matter and deserves their close attention.

Should those engaged in economic forecasting have done a better job of anticipating the downturn? That’s a tougher question. We don’t yet have the available evidence to know, for example, whether the Federal Reserve economists did anticipate it or not. The preliminary evidence from perusal of the minutes of FOMC meetings suggests that they may not have, but we’ll have to wait for the transcripts and release of the Bluebooks and Greenbooks. What is abundantly clear is that there were plenty of other economists who pointed to the growing risks in the housing sector, who pointed to the role that government policies and subsidies played in stimulating the housing sector, who were concerned about the systemic risks posed not only by Freddie and Fannie but by other large institutions, and who pointed to the problems of resolving the failures of large cross-border financial firms. All of these warnings were ignored by policy makers.