Tuesday, February 23, 2010

Why Didn't Economists See The Economic Collapse Coming?

Although economics has typically been viewed as a purveyor of truth and deep understanding about the role of money in society, a recent Wall Street Journal piece indicated that the global economic crisis could have been averted by higher inflation, running counter to the general view of economists over the past twenty-five years. As further proof of the lack of creative thinking among modern economists, a British thinker points out that the economic community failed to predict the systemic crash that occurred. See the following post from The Mess That Greenspan Made.

More evidence that the dismal science as currently practiced may be entering another leg down in what is now a decade long death spiral comes in two reports this morning, the first being this Wall Street Journal item where cutting edge economic thinking has it that higher inflation a few years back might have saved us all from the financial market crash and global economic meltdown eighteen months ago.

For the past quarter century, inflation has been a bogeyman that eats wealth and causes instability. But lately some smart people—including the chief economist at the International Monetary Fund and a senior Federal Reserve researcher—have been wondering aloud if a little more of it might actually be a good thing.
The new argument for inflation goes like this: Low inflation and the low interest rates that accompany it leave central banks little room to maneuver when shocks hit. After Lehman Brothers collapsed in 2008, for example, the U.S. Federal Reserve quickly cut interest rates to near zero, but couldn't go any lower even though the economy needed a lot more stimulus.

Economists call this the "zero bound" problem. If inflation were a little higher to begin with, and thus interest rates were a little higher, the argument goes, the Fed would have had more room to cut interest rates and provided more juice to the economy.

Yes, the problem was that inflation wasn't high enough...

Sadly, if economists had not been so dimwitted in making the disastrous mistake of thinking that real estate was more of an investment than a consumer good and then pulling home prices out of the official measure of inflation back in the 1980s, even they would have seen that there were serious problems beginning seven or eight years ago when something could have been done about a nascent housing bubble before it nearly destroyed the world.

In the world of dismal scientists, if something doesn't show up in the data, it doesn't exist, so, the housing bubble never existed - that is, until it burst.

Economists across the pond don't seem to be making any better progress in getting back in touch with the real world, though, the use of the word 'back' is, perhaps, being generous.

In the Telegraph today, Edmund Conway writes of being mystified by the ongoing debate about whether deficits should be cut sooner rather than later as it misses some very fundamental points about the current condition.

In short, I am dismayed by it. In fact, I would go further and say it illustrates why the economists’ profession simply hasn’t learnt from the atrocious intellectual and policy mess it made ahead of the crisis.
One of the things we learnt from the crisis is that there was a dearth of people propounding truly counterintuitive, counterfactual economic theories. And that those who did were simply ignored. The mainstream failed to see the woods from the trees. It became obsessed with far smaller debates (productivity, protectionism etc) but failed to step back and ask whether the entire edifice of financial economics was about to collapse, which, of course it did. But despite this neglect, the economists always seemed busy.

My feeling is that we’re in a similar position now. These letters represent a similar mirage of intellectual activity which disguises the fact that the economic mainstream is again neglecting deeper questions about where we’re heading. But then perhaps that’s what always happens when politics and economics collides.
It looks like it's going to be another bad year for the economics profession, though they remain an optimistic bunch, predicting just this morning that the U.S. recovery will grow steadily this year and next with jobs returning aplenty.

Lynn Reaser, president of the National Association for Business Economics, commented on the late-January survey of 48 economist noting, "We see a healthy expansion under way, although it will take time to reduce economic slack and repair damaged balance sheets."

We'll find out just how healthy the economic expansion is soon enough.

This post has been republished from Tim Iacono's blog, The Mess That Greenspan Made.

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