"Economists and the Crisis"

This is from Philip Lane at the Irish Economy Blog:

Economists and the Crisis, by Philip Lane: As has been tracked by several previous posts on this blog, there is by now a considerable debate on what the crisis teaches us about the role of economists.

One dimension of this debate has focused on the failure by the economics profession to predict the onset of the crisis. A second quasi-related dimension relates to the failure to sufficiently appreciate the instability of the pre-crisis financial system. To some, these failures suggest that those economists who did not accurately predict the crisis should have no role in resolving the crisis and constructing the new post-crisis economic system. This debate is playing out at the global level and also in relation to the domestic situation.

These are all big issues and I do not attempt to provide a comprehensive set of answers here. Nevertheless, it may be useful to make a few points. I also mainly focus on the role of academic/research economists and the field of macroeconomics.

First, there is no doubt that the crisis has underlined a mis-allocation of research resources. Over the last 15-20 years, monetary economics in relation to the advanced economies has focused on the analysis of ‘low-amplitude’ business cycles. While business cycles were certainly shallow during this period, the social costs of rare-but-large crashes are so large that it is clear in retrospect that too few researchers were focused on the economics of large crises. (An exception relates to those who focused on emerging market economies, where a lot of analysis has been conducted of the recurrent crises that have affected these economies.)

One role for the economics profession is to attempt to forecast the future behaviour of the economy. This is mainly done by economists in policy roles (since policymaking requires projections of future economic performance) and economists in financial firms (since the return on financial investments also turn on future economic performance).

In fact, very few academic economists get involved in this task: to do it well really requires a lot of data resources and and the tracking of many variables, such that is a full-time task that is best conducted by large teams of economists. However, even if not involved in day-to-day forecasting, academic economists can play an important role by providing an independent voice and focusing on ‘big picture’ issues such as whether the forecasting models are well designed and taking a longer-term horizon for forecasting (most forecasting is concerned with quarter-by-quarter developments or, at most, a 1-3 year horizon).

In fact, the main contribution may not be in forecasting per se but in detailing possible contrarian scenarios in order to challenge the conventional wisdom. This can be very valuable but the limitation is that such ‘Cassandra’ warnings typically cannot be tied to a specific date and it is tempting for the mainstream to dismiss such warnings if they do not quickly come to pass. Moreover, if a forecaster’s reputation depends on short-term performance, a bearish economist may quickly lose credibility if boom conditions persist and the day of reckoning is postponed.

However, the main goal in outlining low-probability but high-cost risk scenarios is not so much to alter ‘central’ forecasts but to encourage decisionmakers to adopt prudent strategies that are robust to the occurrence of the ‘disaster’ scenario. In fact, the ideal is that decisionmakers are sufficiently prudent that the risk of the disaster scenario recedes and those offering the Cassandra warnings never see their worst fears realised.

Certainly, we can point to several academic and non-academic economists who were assiduous in making warnings about the consequences of the lending boom and these deserve great credit.

For many others in academia, their research activities were directed towards other questions. In relation to policy-relevant macroeconomics, a major focus has been on conducting research on ‘institutional design.’ That is, rather that focusing on macroeconomic forecasting, many have opted to contribute to the design of policy frameworks that can deliver enhanced stability and lower the cost of crises should they occur. This includes work on: the zero-bound problem in interest rate policy; macro-prudential financial regulation; counter-cyclical fiscal policies; tax policies vis-a-vis the property sector; the establishment of insurance devices such as reserve funds and rainy-day funds and other mechanisms to mitigate macroeconomic risks. Work on such issues has intensified since the onset of the crisis, together with much innovative work in areas such as the design of ‘non-orthodox’ monetary interventions.

Accordingly, the state of macroeconomics is in flux. While there is much to regret concerning the course of pre-crisis research, it is also true that many of the technical innovations over the last 20 years are now being applied in exciting ways to design crisis-resolution policies. Indeed, it is somewhat ironic that the crisis has led to a tremendous resurgence in interest in macroeconomics: economics is much more interesting in ‘bad times’ than in ‘good times’.

Another very promising development has been the enhanced integration of macroeconomics and finance. Many leading finance economists have responded very quickly to the crisis and have written superb analyses of various dimensions of the crisis and developed innovative new policies to restore financial stability and reduce the risk of future crises.

Many of these points apply equally to both the global and local economic situations. Regarding academic research on the Irish economy, I will point out a ’scale’ problem - the small size of the Ireland means that it is difficult to build a successful academic career by focusing on the local economy, in view of the limited publication opportunities and the small size of the domestic profession. This is a problem.

Finally, some have argued that the crisis has shown the limitations of economics. At one level, this is certainly true and an important lesson for all types of decisionmakers is to recognise that the future is uncertain and relying on Panglossian forecasts (where no downside risk is ever realised) is not an appropriate risk management strategy. It is also the case that economics needs to learn more from adjacent disciplines (psychology, history and the other social sciences). However, the likely evolution is an ‘adapted/enriched’ economics rather than a fully-symmetric multi-disciplinary approach, since the technical basis for most economic policy analyses is predominantly driven by economic factors.