Sunday, March 11, 2012

Haunted by the Queen's Question, Paul Krugman tries again to answer it

In a recent speech, Paul Krugman tries again to answer the Queen's question (how come the economics profession did not see the financial crisis coming).
To say the obvious: we’re now in the fourth year of a truly nightmarish economic crisis. I like to think that I was more prepared than most for the possibility that such a thing might happen; developments in Asia in the late 1990s badly shook my faith in the widely accepted proposition that events like those of the 1930s could never happen again. 
But even pessimists like me, even those who realized that the age of bank runs and liquidity traps was not yet over, failed to realize how bad a crisis was waiting to happen – and how grossly inadequate the policy response would be when it did happen.
Pessimism was not a factor in recognizing how bad a crisis was waiting to happen.

Your humble blogger happens to be a very optimistic person.  Yet, your humble blogger predicted the financial crisis.  In fact, your humble blogger even predicted the ongoing severity of the crisis.  Not stopping there, your humble blogger also predicted what policy response was and is still needed to moderate the effects of the crisis.
And the inadequacy of policy is something that should bother economists greatly – indeed, it should make them ashamed of their profession, which is certainly how I feel. For times of crisis are when economists are most needed. 
If they cannot get their advice accepted in the clinch – or, worse yet, if they have no useful advice to offer – the whole enterprise of economic scholarship has failed in its most essential duty. 
And that is, of course, what has just happened....
Actually, the reason that the Queen's Question haunts the economics profession is that the economics profession failed in the inadequacy of its advice in preventing the financial crisis.

In not offering advice that prevented the financial crisis, the whole enterprise of economic scholarship failed in its most essential duty.

Of course, not content to stop there, the economics profession then compounded the damage by having in Professor Krugman's opinion no useful advice to offer since the financial crisis began.
Let me start with a paradox: times of economic disturbance and disorder, of crisis and chaos, are times when economic analysis is especially likely to be wrong. Yet such times are also when economics is most useful. 
Why the paradox? Well, first of all, consider what economics can contribute in calm times. 
The answer, I’d submit, is surprisingly little. OK, economists can explain why the system works the way it does, and offer useful advice about reforms that would make it better; there’s always use for good microeconomics....
What economics had to contribute in calm times was an ongoing reminder of the lessons of the 1930s.

In the 1930s, we learned that financial market participants need access to all the useful, relevant information in an appropriate, timely manner (this is a necessary condition for the invisible hand to operate properly).  We also learned that the cost of market participants not having this information and instead having a financial crisis was a sizable percentage of GNP.

Every year the economics profession could have published an updated cost/benefit analysis showing how much greater the benefit of having ultra transparency is than the cost to provide it.

Using the Bank of England's Andrew Haldane's estimate of the cost of this financial crisis as $4 trillion and my estimate of the cost of the Mother of all financial databases at $50 billion, the cost/benefit analysis shows the benefit from having ultra transparency and not incurring the cost of a financial crisis is 80 times greater than the cost of preventing a financial crisis.

Every year the economics profession could have asked what are the greatest sources of opacity in the financial system and what can be done to bring ultra transparency to them.

For example, George Akerlof's work on accounting control fraud should have resulted in the economics profession pushing to require banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

For example, Joseph Stiglitz's work on information asymmetry should have resulted in the economics profession pushing to require that structured finance products report on an observable event basis (where an observable event includes a payment, delinquency, default or modification involving the underlying collateral) and disclosure occurs after the close of business on the day the observable event occurred.

For example, the economic profession could have pointed out that having banks with an incentive to manipulate the LIBOR interest rate setting this rate behind closed doors would be inviting problems.
The most common accusation against economists in this crisis is that they failed because they didn’t see it coming. Even the Queen of England has demanded that economists explain their failure to predict the crisis. But I would actually defend my colleagues against assertions that this predictive lapse was, in and of itself, all that much of a failure. 
To take the most absurd case, nobody could realistically have demanded that the economics profession predict that Lehman Brothers would go down on September 15, 2008, and take much of the world economy with it....
Actually, economists would prefer that the accusation against them is why didn't they predict the exact date that Lehman failed.  This is easily dismissed because it is absurd to ask anyone to predict the future with that level of specificity.

The Queen did not ask why economists did not predict the exact date of the crisis.  Her question is why they failed to see what was happening and make policy recommendations that would have prevented the crisis.
And this is a terrible thing for those who want to think of economics as useful. 
This kind of situation is what we’re here for. In normal times, when things are going pretty well, the world can function reasonably well without professional economic advice.
Clearly, I believe that there is a role for professional economic advice in keeping the world and, in particular, the financial markets functioning reasonably well.

However, who am I to quarrel with a Nobel prize winner when he says that we could get along without professional economic advice in normal times.
It’s in times of crisis, when practical experience suddenly proves useless and events are beyond anyone’s normal experience, that we need professors with their models to light the path forward. And when the moment came, we failed.
If the observation is accurate that the economics profession failed at a time of crisis, and again who am I to argue with a Nobel prize winner, then one can only conclude that we don't need the economics profession.

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