Here's the introduction to a paper I'm giving at the AEA meetings. The model in the paper, which is a variation of the Brock and Hommes
(1998) generalization of the Lucas (1978) asset pricing model, shows that bad advice from experts can increase the likelihood of harmful financial bubbles:
Bad Advice from Experts, Herding, and Bubbles: The belief that housing prices
would continue to rise into the foreseeable future was an important factor in
creating the housing price bubble. But why did people believe this? Why did they
become convinced, as they always do prior to a bubble, that this time was
different? One reason is bad advice from academic and industry experts. Many
people turned to these experts when housing prices were inflating and asked if
we were in a bubble. The answer in far too many cases – almost all when they had
an opinion at all – was that no, this wasn’t a bubble. Potential homebuyers were
told there were real factors such as increased immigration, zoning laws,
resource constraints in an increasingly globalized economy, and so on that would
continue to drive up housing prices.
When the few economists who did understand that housing prices were far above
their historical trends pointed out that a typical bubble pattern had emerged –
both Robert Shiller and Dean Baker come to mind – they were mostly ignored.
Thus, both academic and industry economists helped to convince people that the
increase in prices was permanent, and that they ought to get in on the housing
boom as soon as possible.
But why did so few economists warn about the bubble? And more importantly for
the model presented in this paper, why did so many economists validate what
turned out to be destructive trend-chasing behavior among investors?
One reason is that economists have become far too disconnected from the
lessons of history. As courses in economic history have faded from graduate
programs in recent decades, economists have become much less aware of the long
history of bubbles. This has caused a diminished ability to recognize the
housing bubble as it was inflating. And worse, the small amount of recent
experience we have with bubbles has led to complacency. We were able to escape,
for example, the stock bubble crash of 2001 without too much trouble. And other
problems such as the Asian financial crisis did not cause anything close to the
troubles we had after the housing bubble collapsed, or the troubles other
bubbles have caused throughout history.
Economists did not have the historical perspective they needed, and there was
confidence that even if a bubble did appear policymakers would be able to clean
it up without too much damage. As Robert Lucas said in his 2003 presidential
address to the American Economic Association, the “central problem of
depression-prevention has been solved.” We no longer needed to worry about big
financial meltdowns of the type that caused so many problems in the 1800s and
early 1900s. But in reality economists hardly knew what to look for, did not
fully understand the dangers, and were hence unconcerned even if they did
suspect that housing prices were out of line with the underlying fundamentals.
A second factor is the lack of deep institutional knowledge of the markets
academic economists study. Theoretical models are idealized, pared down versions
of reality intended to capture the fundamental issues relative to the question
at hand. Because of their mathematical complexity, macro models in particular
are highly idealized and only capture a few real world features such as sticky
prices and wages. Economists who were intimately familiar with these highly
stylized models assumed they were just as familiar with the markets the models
were intended to represent. But the models were not up to the task at hand,
and when the models failed to signal that a bubble was coming there was no deep
institutional knowledge to rely upon. There was nothing to give the people using
these models a hint that they were not capturing important features of real
These two disconnects – from history and from the finer details of markets –
made it much more likely that economists would certify that this time was
different, that fundamentals such as population growth, immigration, financial
innovation, could explain the run-up in housing prices.
The model in this paper examines the implications of these
two disconnects and shows that when experts endorse the idea that this time is
different and cause herding toward incorrect beliefs about the future, it
increases the likelihood that a large, devastating bubble will occur.
 See Wieland and Wolters (2011) for an
overview of the forecasting performance of macroeconomic models before, during,
and after the crisis.