The Queen's Question part II: Paul Krugman defends the economics profession

According to a Financial Times column, in the fall of 2008, the Queen of England put the economics profession and global financial policy makers and regulators on the spot with a simple question.  At the London School of Economics she asked, "if things were so large, how come everyone missed them?"


In Part I of this series of posts, your humble blogger noted that he had in fact publicly predicted the financial crisis, but more importantly had offered a solution that would have moderated the impact of what occurred and prevented future financial crises.  This prediction and proposed solution were based on the FDR Framework.


The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.


In Part II of this series of posts, Paul Krugman defends the economic profession's performance prior to and during the financial crisis.  


Based on what he said in this defense, Professor Krugman should be a very vocal supporter of the FDR Framework.     

There is a real sense in which times like these are what economists are for, just as wars are what career military officers are for .... But macroeconomics is, above all, about understanding and preventing or at least mitigating economic downturns. This crisis was the time for the economics profession to justify its existence....

We have not, to put it mildly, delivered.

What do I mean by that? As I see it, there are three main complaints one can make about economists and their role in the current crisis. First is the complaint that economists fell down on the job by not seeing the crisis coming. Second is the complaint that economists failed even to see the possibility of this kind of crisis — and that by pointing out the possibility, they could have helped head the crisis off. Third is the complaint that they have either failed to offer useful advice on what to do after the crisis struck, or that they have offered such a cacophony of voices as to provide no useful guidance for policy....

Under Professor Krugman's criteria, your humble blogger has delivered.  This includes publicly seeing the crisis coming, attempting to head off the crisis and, through development of the FDR Framework, providing useful advice on what to do after the crisis struck. 

What should economists have known about the impending crisis, and when should they have known it?

Ask any one economist that question, and by and large the answer is that they should have known what he or she knew, and can be excused for not knowing more. Me too!

Clearly, it's not fair to demand that economists have known that Lehman would go bust on September 15, 2008; in fact, I think most people would agree that it's unrealistic to have expected economists to get either the year of the crisis or the firms that fell first right. But should they have seen a crisis building several years before it happened? Should they have had at least a rough idea of how bad it would be?

Well, from my point of view — which, because I’m like everyone else, is that what I saw and no more is what everyone should have seen — it still seems bizarre how many economists failed to see that we were experiencing a monstrous housing bubble.

As Robert Shiller has documented — and, crucially, was documenting in real time circa 2004–5–6 [Shiller 2005] — the rise in real housing prices after 2002 or so took them into completely unprecedented territory. It was the clearest market mispricing I’ve seen in my professional life, even more obviously out of line than the dot-com bubble, which at least had the excuse that it involved novel technologies with unknown potential; houses have been with us for 7,000 years or so, and we should have a reasonable idea of what they’re worth.

So why were so relatively few economists willing to call the bubble? I suspect that efficient market theory, in a loose sense — the belief that markets couldn’t possibly be getting things that wrong — played a major role. And in that sense there was a structural flaw in the profession.

If a belief in the efficient market hypothesis is really why few economists were willing to call the bubble, then Professor Krugman and the economics profession should race to embrace the FDR Framework.

An important assumption underpinning the efficient market hypothesis is that market participants have access to all useful, relevant information in an appropriate, timely manner.  This was and is not the case for structured finance securities and financial institutions.
For structured finance securities, Wall Street intentionally preserved its informational advantage on the current performance of the underlying loans.  By doing so, Wall Street knew it could easily profit on the mis-pricing of risk by the other market participants. For financial institutions, regulators were given an information monopoly during the Great Depression.  As a result of this monopoly, all the other market participants are dependent on the regulators properly assessing the risk of the financial institutions.
  The FDR Framework brings structured finance securities and financial institutions back into compliance with the assumptions underlying the efficient market hypothesis.

What about what would happen when the bubble burst? I personally failed to realize how big the “knock-on” effects would be; and according to the self-justifying principle, I’m tempted to say that nobody could reasonably have been expected to get that right. But actually, we should have seen that coming too — maybe not in full detail, but even a casual walk through historical crises should have indicated that a housing bust was likely to bring large financial and balance-sheet problems in its wake. I kick myself every once in a while for failing to think that part through. In particular, those of us who had worked on the Asian financial crisis of the 1990s had placed large weight on balance-sheet effects [Krugman 1999]. Why didn’t I think of applying the same logic to the coming bust in US home prices?

Beyond that, surely experts in banking and finance should have been aware of rising leverage, of the growing reliance on unregulated shadow banking, and so on. It's quite remarkable how few warnings we had that the system might be dangerously fragile. By all means, let's give credit to people like Rajan [2005] who saw some of it; but the very fact that such people were given a hard time for their analysis is telling about the profession.

Perhaps not surprisingly, the very people that give me a hard time are economists - OK, Wall Street does too, but that is to be expected because I trying to eliminate the profits they make from opacity.

Still, as Yogi Berra said, it's tough to make predictions, especially about the future. There are so many things going on in the world, many of them off any modeler's radar, that the profession's failure to see this crisis coming is not, in my mind, anything close to its biggest sin....

Regular readers know that the predictions made on this blog have in fact come to pass.

One can make excuses for the failure of the economics profession to foresee that the 2008 financial crisis would happen. It's much harder to make such excuses for much of the profession's failure to realize that such a thing could happen.

Banking crises are, after all, a theme running through much of modern economic history. Nobody should be able to call himself a macroeconomist unless he has a working knowledge of what went down in 1931, both in the United States and in Europe.

 And you don’t have to go back to the 1930s, either, as long as you’re willing to step outside the United States and core Europe. With the Scandinavian crises of the early 1990s, the Asian crises of the late 1990s, Argentina, and so on, there should have been ample reason to at least consider whether it might happen here....

The overall point should be clear: economists had good enough intellectual frameworks to have seen the risk of something like the banking and balance sheet crisis that burst upon us in 2008. But they ignored that risk.

My best answer is that they were caught up in the spirit of the times, with its faith in the wisdom of markets and of the financial industry. Nobody could deny the possibility of runs on conventional banks, which have happened so often in history. Few could deny that debt deflation had happened in the past.

But to argue, or even to think about, the possibility that the old evils could manifest themselves in new forms would have been to question the whole basis of decades of policy, not to mention the foundations of a very lucrative industry. You don’t have to invoke raw corruption (although there may have been some of that) to see why this was a line of thought few were willing to pursue. And by not pursuing that line of thought, the profession fell down badly on the job.

I wonder what economists who studied the Great Depression looked at if not how the financial system was designed to prevent the old evils from manifesting themselves.

The FDR Framework has its roots in the financial system designed in the 1930s.  Specifically, it includes the philosophy of disclosure.  The FDR Framework takes this philosophy and applies it using 21st century information technology.

21st century information technology allows the FDR Framework to bring the disinfectant of sunlight to those areas of the capital markets that are currently hidden from view.  This includes the performance of the loans underlying structured finance securities as well as what is happening on and off bank balance sheets.

The FDR Framework also has its roots in earlier financial systems and the practice of caveat emptor (buyer beware).  Under caveat emptor, buyers are responsible for all gains and losses.

Being responsible for all gains and losses provides plenty of incentive to use the information provided under the FDR Framework to assess the riskiness of an investment prior to investing and while an investor in a specific security.

Yet the profession's worst failure wasn’t what it failed to see before the crisis. It was what happened after crisis struck....

We’ve entered a Dark Age of macroeconomics, in which much of the profession has lost its former knowledge, just as barbarian Europe had lost the knowledge of the Greeks and Romans.

As long as monetary policy could bear the burden of macroeconomic stabilization, this didn’t seem to matter too much: even as equilibrium business cycle theory became increasingly dominant in graduate study, central banks, like medieval monasteries, kept the old learning alive. But once we were hit with such a severe banking and balance sheet crisis that monetary policy hit the zero lower bound, it was crucial that the economics profession be able to weigh in knowledgeably and coherently on other possible actions. And it turned out that it couldn’t....

And the result was that faced with a severe economic crisis, the profession spoke with a cacophony of voices. Or maybe a better way to put it is that the policy debate of 2009–2010 was virtually indistinguishable from the policy debate of 1931–1932.

Long-refuted doctrines that should have been consigned to the dustbin of history were stated as if they were fresh new ideas — and they were fresh and new to many economists, because our profession had lost so much of its heritage.

In short, in responding to the crisis, the profession presented a sorry spectacle of unnecessary ignorance that didn’t even recognize itself as ignorance, of bitter debate over issues that were resolved many decades earlier. And all of this, of course, made the profession mostly useless at a time when it could and should have been of great service. Put it this way: we would have responded better to this crisis if macroeconomics had been frozen at the level of knowledge it had in 1948, when Paul Samuelson published the first edition of his famous textbook. ... 

I’m sorry if I have painted a bleak picture of the role of economists in the crisis. Unfortunately, that's the way it looks to me. So what can be done to improve that picture?

Some economists are pushing forward with new macroeconomic models that incorporate the lessons of the crisis. Me too! And by all means, let's do that. But as I’ve said, our big problem was not lack of models.

There are also many calls for new economic thinking; there's even an institute dedicated to that project. Again, fine — but the biggest problem we had as a profession wasn’t failure to keep up with a changing world, it was failure to remember what our fathers learned.

 And what our fathers learned was that disclosure is the key to restoring confidence in the financial system.  The FDR Framework updates disclosure for the realities of the 21st century.