The Queen's Question: Why did economists fail to predict the financial crash?

In a Guardian column, Costas Douzinas relates the Queen's question to the failure of policies being advocated by the IMF and its economists in Greece.

During an official visit to the LSE in November 2008, the Queen asked a professor why economists had failed to predict the financial crash, the most dramatic event in recent economic history....

A year later, after a British Academy seminar, eminent economists answered by blaming "a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole".

Your humble blogger needs to make a confession.  First, I am not an eminent economist.  Second, I did not have a failure to predict the financial crash ... I did predict the crash and the failure of policies that have been implemented since to restore a global financial system that functions without massive amounts of government intervention.

I also happen to have two college age sons who helped me to understand why in general the economics profession missed the financial crisis [by the way, there were two economists - William White and Claudio Borio - who did predict the sub-prime portion of the crisis; whether they predicted the sovereign debt crisis is another matter].

My sons have taken a number of courses in micro and macro economics.  They report that economists tend to be very bright and fit the classic profile of individuals who exhibit group think.  Economists agree on the assumptions underlying Economics 101.

Knowing their Dad's interest, they both waited to hear how the invisible hand only works in markets where buyers have access to all the useful, relevant information in an appropriate, timely manner.

This was never mentioned in their coursework including lectures, discussion sections or reading.  It was never mentioned even when the economists were describing what they thought were the causes of the financial crisis and talked about opaque, toxic sub-prime mortgage backed securities.

In fact, the closest any professor came to mentioning this was when the focus was on market imperfections and information asymmetry was cited as an example.  Buyers having access to all the useful, relevant information in an appropriate, timely manner and information asymmetry are not the same thing.

How could economists be expected to have predicted the financial crisis when the role of buyers having access to all the useful, relevant information in an appropriate, timely manner (transparency) is not taught in Economics 101?

Based on my own conversations with economists, they treat transparency either as a) something they assume occurs, b) trivial or c) difficult to add to their models of financial markets (see the efficient market hypothesis) or the economy.

Despite this, most of the economists could not have been more helpful in trying to flush out potential objections to or problems with transparency and the FDR Framework.  This help may have been driven by the realization and perhaps even recognition that their preferred solutions for the financial crisis required transparency.

These economists helped me walk through the relevant analyzes and prove that transparency and, by extension, the FDR Framework is parsimonious (it is the model of how the financial system works that requires the fewest assumptions and has the best predictive value).

Interestingly, even though these economists recognized that transparency as required under the FDR Framework provided the simplest solution to the financial crisis, they still preferred their much more complex, transparency dependent solutions.

Please re-read the eminent economists excuse for not predicting the financial crisis and focus on the failure of collective imagination to understand the risks to the system.

To restate the excuse the profession offers up:  even though we are bright, nobody could possibly expect us to understand all the risks in the modern, complex global financial system.

Nobody asked them to understand all the risks in the modern, complex global financial system.  


They were asked to understand that transparency is needed for properly functioning markets and that opacity is at the top of the list of market imperfections.

They missed not because of a lack of intelligence or failure of imagination, but because in their first course in economics the professor never said that the invisible hand only works for markets where buyers have access to all the useful, relevant information in an appropriate, timely manner.

Update
The Guardian carried another relevant column related to addressing economics and the Queen's question.

The world is full of people proclaiming about stuff they don't know much about. My trade depends on it. Pundits, politicians and economists, too, all depend on some kind of bladder-busting meta-analysis to keep us quiet. In fact, they are just winging it. 

Too many nights I have watched economists on television being treated with undeserved reverence. "Economics is largely a made-up pseudo-science!" I want to scream. 

After all, it has been almost entirely useless in predicting the mess we are in. 

Indeed, by coming up with grotesque calculations whereby rich people's investments were effectively risk-free and financed by the jobs and homes of the poor, many economists were cheerleaders pre-crisis.