Tuesday, September 22, 2009

Shiller Says We Need More Research On Economic Bubbles

With the failure of current economic models to give adequate warning of the current financial crisis, Robert Shiller says we need more research of bubbles and what their role should be in economic models. If we had a better understanding of bubbles, could we prevent them from reaching dangerous levels or detect trouble much sooner? The following article summarized by the Economist's View discusses this topic.

Robert Shiller says economists and their models need to take bubbles seriously (compare Dani Rodrik's "Blame Economists, not Economics"):

Economists need to study bubbles, reinvent models, by Robert Shiller, Commentary, Project Syndicate: The widespread failure of economists to forecast the financial crisis ... has much to do with faulty models. This lack of sound models meant that economic policymakers and central bankers received no warning of what was to come. ...

[T]he current financial crisis was driven by speculative bubbles in the housing market, the stock market, energy and other commodities markets. ... You won’t find the word “bubble,” however, in most economics treatises or textbooks. Likewise, a search of working papers produced by central banks and economics departments in recent years yields few instances of “bubbles” even being mentioned. Indeed, the idea that bubbles exist has become so disreputable ... that bringing them up in an economics seminar is like bringing up astrology to a group of astronomers.

The fundamental problem is that a generation of mainstream macroeconomic theorists has come to accept a theory that has an error at its very core — the axiom that people are fully rational. ...

[E]conomists assume that people ... use all publicly available information and know, or behave as if they know, the probabilities of all conceivable future events. ... They update these probabilities as soon as new information becomes available and so any change in their behavior must be attributable to their rational response to genuinely new information. If economic actors are always rational, then no bubbles — irrational market responses — are allowed. ...

In fact, people almost never know the probabilities of future economic events. They live in a world where economic decisions are fundamentally ambiguous, because the future doesn’t seem to be a mere repetition of a quantifiable past. ...

To be sure, the purely rational theory remains useful for many things. ... Economists have also been right to apply his theory to a range of microeconomic issues... The theory, however, has been overextended. For example, the “Dynamic Stochastic General Equilibrium Model of the Euro Area,” developed by Frank Smets ... and Raf Wouters..., is very good at giving a precise list of external shocks that are presumed to drive the economy, but nowhere are bubbles modeled. The economy is assumed to do nothing more than respond in a completely rational way to these external shocks.

Milton Friedman and Anna Schwartz, in their 1963 book A Monetary History of the United States, showed that monetary-policy anomalies — a prime example of an external shock — were a significant factor in the Great Depression of the 1930s. ... To some, this revelation represented a culminating event for economic theory. The worst economic crisis of the 20th century was explained — and a way to correct it suggested — with a theory that does not rely on bubbles.

Yet events like the Great Depression, as well as the recent crisis, will never be fully understood without understanding bubbles. The fact that monetary policy mistakes were an important cause of the Great Depression does not mean that we completely understand that crisis, or that other crises fit that mold.

In fact, the failure of economists’ models to forecast the current crisis will mark the beginning of their overhaul. This will happen as economists’ redirect their research efforts by listening to scientists with different expertise. Only then will monetary authorities gain a better understanding of when and how bubbles can derail an economy and what can be done to prevent that outcome.
This post has been republished from Mark Thoma's blog, Economist's View.

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