Why
Economists Failed to Predict the Financial Crisis
There is a long list of professions that failed to see
the financial
crisis brewing. Wall Street bankers and deal-makers top it, but banking
regulators are on it as well, along with the Federal Reserve.
Politicians and journalists have shared the blame, as have mortgage
lenders and even real estate agents.
But what about economists? Of all the experts, weren't
they the best
equipped to see around the corners and warn of impending disaster?
Indeed, a sense that they missed the call has led to
soul searching
among many economists. While some did warn that home prices were
forming a bubble, others confess to a widespread failure to foresee the
damage the bubble would cause when it burst. Some economists are
harsher, arguing that a free-market bias in the profession, coupled
with outmoded and simplistic analytical tools, blinded many of their
colleagues to the danger.
"It's not just that they missed it, they positively
denied that it would happen," says Wharton finance professor Franklin
Allen,
arguing that many economists used mathematical models that failed to
account for the critical roles that banks and other financial
institutions play in the economy. "Even a lot of the central banks in
the world use these models," Allen said. "That's a large part of the
issue. They simply didn't believe the banks were important."
Over the past 30 years or so, economics has been
dominated by an
"academic orthodoxy" which says economic cycles are driven by players
in the "real economy" -- producers and consumers of goods and services
-- while banks and other financial institutions have been assigned
little importance, Allen says. "In many of the major economics
departments, graduate students wouldn't learn anything about banking in
any of the courses."
But it was the financial institutions that fomented the
current
crisis, by creating risky products, encouraging excessive borrowing
among consumers and engaging in high-risk behavior themselves, like
amassing huge positions in mortgage-backed securities, Allen says.
As computers have grown more powerful, academics have
come to rely
on mathematical models to figure how various economic forces will
interact. But many of those models simply dispense with certain
variables that stand in the way of clear conclusions, says Wharton
management professor Sidney
G. Winter. Commonly missing are hard-to-measure factors like
human psychology and people's expectations about the future, he notes.
Among the most damning examples of the blind spot this
created,
Winter says, was the failure by many economists and business people to
acknowledge the common-sense fact that home prices could not continue
rising faster than household incomes.
Says Winter: "The most remarkable fact is that serious
people were
willing to commit, both intellectually and financially, to the idea
that housing prices would rise indefinitely, a really bizarre idea."
Although many economists did spot the housing bubble,
they failed to fully understand the implications, says Richard
J. Herring,
professor of international banking at Wharton. Among those were dangers
building in the repo market, where securities backed by mortgages and
other assets are used as collateral for loans. Because of the
collateralization, these loans were thought to be safe, but the
securities turned out to be riskier than borrowers and lenders had
thought.
The Dahlem Report
In a highly critical paper titled, "The
Financial Crisis and the Systemic Failure of Academic Economists,"
eight American and European economists argue that academic economists
were too disconnected from the real world to see the crisis forming.
The authors are David Colander, Middlebury College; Hans Follmer,
Humboldt University; Armin Haas, Potsdam Institute for Climate Impact
Research; Michael Goldberg, University of New Hampshire; Katarina
Juselius, University of Copenhagen; Alan Kirman, University
d'Aix-Marseille; Thomas Lux, University of Kiel; and Brigitte Sloth,
University of Southern Denmark.
"The economics profession appears to have been unaware
of the long
build-up to the current worldwide financial crisis and to have
significantly underestimated its dimensions once it started to unfold,"
they write. "In our view, this lack of understanding is due to a
misallocation of research efforts in economics. We trace the deeper
roots of this failure to the profession's insistence on constructing
models that, by design, disregard the key elements driving outcomes in
real world markets."
The paper, generally referred to as the Dahlem report,
condemns a
growing reliance over the past three decades on mathematical models
that improperly assume markets and economies are inherently stable, and
which disregard influences like differences in the way various economic
players make decisions, revise their forecasting methods and are
influenced by social factors. Standard analysis also failed, in part,
because of the widespread use of new financial products that were
poorly understood, and because economists did not firmly grasp the
workings of the increasingly interconnected global financial system,
the authors say.
One result of this, argues Winter, who is not one of the
authors but
agrees with much of what they say, is to build into models an
assumption that all market participants -- bankers, lenders, borrowers
and consumers -- behave rationally at all times, as if they were
economists making the most financially favorable choices. Clearly, he
says, rational behavior is not that dependable, or else people would
not do self-destructive things like taking out mortgages they could not
afford, a key factor in the financial crisis. Nor would completely
rational executives at financial firms invest in securities backed by
those risky mortgages, which they did.
By relying so heavily on the view of humans as rational,
the paper's
authors argue, economists ignore evidence of irrational behavior that
is well documented in other disciplines like psychology and sociology.
Even if an individual does act rationally, economists are wrong to
assume that large groups of people will react to given conditions as an
individual would, because they often do not. "Economic modeling has to
be compatible with insights from other branches of science on human
behavior," they write. "It is highly problematic to insist on a
specific view of humans in economic settings that is irreconcilable
with evidence."
The authors say economists badly underestimated the
risks of new types of ,
which are financial instruments whose value fluctuates, often to
extremes, according to the changing values of underlying securities.
Traditional
such as stock options and commodities futures are well understood. But
exotic
devised in recent years, including securities built upon pools of
mortgages, turned out to be poorly understood, the authors say. Credit
default swaps, a form of derivative used to insure against a borrower's
failure to repay a loan, played a key role in the collapse of American
International Group.
Rather than accurately analyzing the risks posed by new ,
many economists simply fell back on faith that creating new financial
products is good, the authors write. According to this belief, which
was promoted by former Federal Reserve chairman Alan Greenspan, a wider
variety of financial products allows market participants to place ever
more refined bets, so the markets as a whole better reflect the
combined wisdom of all the players. But because there was not enough
historical data to put into models used to price these new ,
risk and return assessments turned out to be wrong, the authors argue.
These securities are now the "toxic assets" polluting the balance
sheets of the nation's largest banks.
"While the economic argument in favor of ever new
is more one of persuasion rather than evidence, important negative
effects have been neglected," they write. "The idea that the system was
made less risky with the development of more
led to financial actors taking positions with extreme degrees of
leverage, and the danger of this has not been emphasized enough."
'Control Illusion'
When certain price and risk models came into widespread
use, they
led many players to place the same kinds of bets, the authors continue.
The market thus lost the benefit of having many participants, since
there was no longer a variety of views offsetting one another. The same
effect, the authors say, occurs if one player becomes dominant in one
aspect of the market. The problem is exacerbated by the "control
illusion," an unjustified confidence based on the model's apparent
mathematical precision, the authors say. This problem is especially
acute among people who use models they have not developed themselves,
as they may be unaware of the models' flaws, like reliance on uncertain
assumptions.
Much of the financial crisis can be blamed on an
overreliance on
ratings agencies, which gave complex securities a seal of approval,
says Wharton finance professor Marshall
E. Blume. "The ratings agencies, of course, use models" which
"grossly underestimated" risks.
"Any model is an abstraction of the world," Blume adds.
"The value
of a model is to provide the essence of what is happening with a
limited number of variables. If you think a variable is important, you
include it, but you can't have every variable in the world.... The
models may not have had the right variables."
The false security created by asset-pricing models led
banks and
hedge funds to use excessive leverage, borrowing money so they could
make bigger bets, and laying the groundwork for bigger losses when bets
went bad, according to the Dahlem report authors.
At the time, few people knew that major financial
institutions had
become so heavily leveraged in real estate-related assets, says Wharton
finance professor Jeremy
J. Siegel.
"Had they not been in that situation, we would not have had the
crisis," he says. "We may not even have had a recession.... Macro
economists really hadn't talked about it because these structured
financial products were relatively new," he adds, arguing that
economists will have to scrutinize the balance sheets of major
financial institutions more closely to detect mushrooming risks.
Lessons Not Learned
Prior to the latest crisis, there were two well-known
occasions when
exotic bets, leverage and inadequate modeling combined to create
crises, the paper's authors say, arguing that economists should
therefore have known what could happen. The first case, the stock
market crash of 1987, began with a small drop in prices which triggered
an avalanche of sell orders in computerized trading programs, causing a
further price decline that triggered more automatic sales.
The second case was the 1998 collapse of the Long-Term
Capital
Management (LTCM) hedge fund. It had built up a huge position in
government bonds from the U.S. and other countries, and was forced into
a wave of selling after a Russian government bond default knocked bond
prices down.
"When there's a default in one kind of bond, it causes
reassessment of all the risks," says Wharton economics professor Richard
Marston.
"I don't think we have really fully learned from the LTCM crisis, or
from other crises, the extent to which things are illiquid." These
crises have shown that market participants can rely too heavily on the
belief they can quickly unload securities that decline in price, he
says. In fact, the downward spiral can be so rapid that it leaves
investors with losses far larger than they had thought possible.
In the current crisis, he says, economists "should get
blamed for
the overall unwillingness to take into account liquidity risk. And I
think it's going to force us to reassess that."
Academics also are beginning to reassess business-school
curricula. Wharton management professor Stephen
J. Kobrin
recently moderated a faculty panel that talked about a wide range of
possible responses to the crisis. Among the issues discussed, he says,
was whether Wharton's curriculum should include more on regulation and
risk management, as well as executive education programs for regulators
and other government officials.
Kobrin said he believes many academics share "an
ideological
fixation with free markets and lack of regulation" that should be
reexamined. "Obviously, people missed the boat on a lot of the risks
that a lot of financial instruments entailed," he says. "We need to
think about what changes are needed in the curriculum."
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