Acemoglu: The Models are Broken

Simon Johnson summarizes an essay by Daron Acemoglu discussing lessons to be learned from the "crisis of 2008":

Causes: Economics, by Simon Johnson: We ... should listen when a leading expert on a large set of influential models says (1) they are broken, and (2) this helped cause the crisis and - unless fixed - will lead to further instability down the road.

This is an important part of what my colleague, Daron Acemoglu, is saying in a new essay, “The Crisis of 2008: Structural Lessons for and from Economics.” ... To me there are three major points in his essay.

1. The seeds of the crisis were sown in the Great Moderation... Everyone who patted themselves or others on the back during that time was really missing the point... The same interconnections that reduced the effects of small shocks created vulnerability to massive system-wide domino effects. No one saw this clearly.

2. The predominant view was that the US and other relatively rich countries had pretty good institutions ... and that these institutions would prevent powerful people from the kind of abuse that endanger social systems in many parts of the world... That view was incorrect. (Speaking personally, I had no illusions about the power of the strongest on Wall Street - particularly after my experience on the SEC’s Advisory Committee on Market Information in 2000-2001. But I didn’t have the right mental model of how this power aggregated up, i.e., the way in which these people, and the firms they controlled, had created or recreated a deeply unstable system.)

3. The way we think about reputation, including how it is acquired and maintained, is way off base... You walk into a grocery store with a mental model that is based on the premise that the individuals all through the production chain operate in a control structure designed to build brands and make you think their products are healthy and tasty. Such reputations are costly to build and not readily squandered. But, Daron points out, this is too simple. In particular, we should no longer make the mistake of saying “the company” wants this or that. There are no companies in any kind of behavioral sense. There are people, struggling to get ahead, and it is their interactions that can lead - particularly in finance - to products that are really terrible for you and your neighbors (and even quite bad for themselves).

Daron also urges that we not lose track of longer term economic growth issues... If the bailout process ... slows down or even freezes the reallocation of resources out of the financial sector, we have a problem. We need to move, at least somewhat, out of a bloated financial sector and back into the kind of nonfinancial technology-developing sectors that have primarily driven growth in the US since the 1840s.

This is not an argument against a comprehensive stimulus package. But it recognizes the legitimacy of any backlash both against the models that brought us here and many of the sweet deals for leading financial figures...  Beginning with designing, arguing about, and implementing the stimulus, we need to think more clearly about the economics and politics of how we rebuild the financial system. If we recreate something fundamentally unfair and unstable, that will also undermine growth.