In December 2002 the American Economic Review, one of the most prestigious economic journals, carried a paper by Sven Bouman and Ben Jacobsen called “The Halloween Indicator” in which they showed that selling equities in May and buying on Halloween had paid off very well. Anybody who had followed this advice would have sold shares in May 2008 and thus saved themselves a massive loss*.
This is not the only way in which economics predicted the crash. In 2007, I warned that a good lead indicator of equity returns – foreign buying of US shares – was predicting big losses.
In these two senses, economics did foresee the crash. Contrary to Andy Haldane, there was no “Michael Fish moment”.
So, does this mean I agree with David Miles that economics has done just fine?
No.
For one thing, these two examples suggest that he is wrong to say that crises are “virtually impossible to predict”. They did indeed predict a crisis. They suggest that aggregate stock markets are not wholly rational. Such a view isn’t terribly heterodox: it was Paul Samuelson, the granddaddy of orthodoxy, who said stock markets were “"micro efficient but macro inefficient**."
We must distinguish here, however, between explanation and prediction. As Jon Elster stressed, these are two different things. These indicators predicted a crisis, but didn’t explain it.
There is, though, a second reason why I disagree with David. His correct claim that standard economics has models of crises and bank runs overlooks the fact that, as Dani Rodrik says, the art of economics lies in applying the right model to the right situation. And many economists failed to do this in the md-00s. Rather than point to increasing bank leverage as a potential cause of trouble, they were talking of the “great moderation.” And they perhaps focused too much on DSGE models that explained stability – or at least regarded shocks as exogenous – and too little upon Minsky-type models in which crises were endogenous.
However, although I’m unhappy with some defences of economics, there’s something about attacks upon the subject that troubles me.
Quite simply, economists were not, for the most part, responsible for the 2008 crash – except perhaps insofar as their talk of the great moderation emboldened banks to take more risk. It wasn’t us, for example, that said it was a good idea to take over ABN Amro (quite the opposite!). Instead, the crisis was caused by bankers. Criticisms of economics deflect attention from this truth – and in doing so, they serve a reactionary function.
* Updated and ungated pdf here. The rule would have meant missing out on decent profits in the summers of 2003 and 2005, however – although the UK market performed as well as cash in 2004, 2006 and 2007.
** Actually, the defensive and momentum anomalies suggest they aren’t wholly micro efficient either, but let that pass.
The problem is economists who provide cover for progressive neoliberal politicians like Bill and Hillary Clinton, like defense attorneys. They damage economics by association.
Now voters no longer listen to or trust economists or experts in the media.
Economists and the corporate media were squarely against both Brexit and Trump and voters ignored their warnings.
Posted by: Peter K. | January 13, 2017 at 02:32 PM
A lot of economist pedal that line about bankers being responsible for the crisis but this strikes me as an attempt to deflect blame. Bankers were the proximate cause but the ultimate were the Governments and their economic advisers who aggressively promoted deregulation. Larry Summers was a keen advocate as was Ed Balls. Any comment on this by an economist treated with a degree of skepticism. Better ask a historian (although maybe not Niall Ferguson).
Posted by: Stewart S | January 13, 2017 at 06:37 PM
I want to point out that total leverage has never actually been a good lead for crises (I believe Noah Smith discussed this once but I can't find the article). What matters is the quality of loans (and that's often hard to get data on), not some aggregate ratio.
Posted by: Britonomist | January 13, 2017 at 07:05 PM
Yes a profession that has no problem with warning of public finance crises unless defecits are cut, or currency crises if current account defecits aren't, has no business bleating about crises not being predictable. You can still warn about the risks and draw attention to indicators. In particular, the way in which you depiect the financial system can be 'prone to acts of self destruction' not 'knows what it's doing best left alone'. Britmouse may be right that leverage is a bad risk indicator, but economists weren't even looking for one.
Posted by: Luis Enrique | January 13, 2017 at 07:57 PM
That the Derivatives Emperor had no clothes was evident in the years leading up to the crash. Unfortunately, those who pointed this out at the time were silenced by greedy bank managers and ignored by sycophantic regulators. The problem remains that people are heavily incentivised to take risks with others' money and not penalised if they fail. Regulation may have upped its game since then, but not a lot.
The crash was entirely predictable and was predicted - it just wasn't talked about.
There seems to be no political appetite for meaningful reform of the sector, so the seeds are there for the next banking crisis.
Posted by: Mark Evens | January 14, 2017 at 11:29 AM
Some economists, especially Milton Friedman and his followers, provided the rational and the ideology for deregulation (and the later claim that risk could be quantified, priced and traded). See An Engine Not a Camera. While I believe that it is true that most economists, micro and macro, were unaware of the mortgage lending practices and actual economics of securitization, that is not to their credit. Tens of thousands of traders, lawyers and accountants did. See The Fall of the House of Lehman.
Posted by: Displaced Person | January 14, 2017 at 12:22 PM
The mistake economists made, and keep making , is saying that there models performed well before the crisis. Even Haldane said this. A key point Minsky makes is that it precisely when things look OK when in reality they are not. As a Marxist you are aware that the problems leading up to 2008 were long in the making - and relate to deindustrialisation, financialisation and social problems such as inequality in advanced countries. It is not a case of picking the right model. It is a case of looking at what is going on and being historically very literate. Put another way, it is working more like those in the other social sciences and humanities. Do we use a model to explain the causes of WWII? No. A proper historian forgets models and looks at everything involved leading up to that event. When trying to work out what the long terms trends are, we should be working the same way.
Lucas and Sargent with sticky prices does not tell us anything useful at all. It should be very clear to most sensible people by now.
NK.
Posted by: Nanikore | January 14, 2017 at 01:32 PM
I am not up for a rant this morning, but yes, the banksters (a term from the Great Depression) caused the financial crisis. And, at least in the US, there is evidence that they were aware of the danger, which is why they engineered changes in the bankruptcy law in 2005. But the politicians are supposed to keep the bankers in check, which they not only failed to do, they actively dismantled protections put in place in the wake of the Great Depression, despite the huge red flag of the S&L crisis. And the politicians rely, in no small part, on the advice of economists. Where were the economists warning that that might not be a good idea? Where?
Alan Greenspan, the so-called Maestro, infamously said that laws against financial fraud were unnecessary, because the financial sector is self-regulating. Where did he get that cockamamie notion? Maybe from a tete-a-tete with Ayn Rand, but most likely the idea originated with laissez-faire economists. Greenspan combined with Geithner and Larry Summers, a noted economist, to squelch Brooksley Born's attempt to regulate derivatives. (And it was derivatives that greatly amplified the damage from the mortgage crisis.) And, as head economics advisor to Obama, Summers put a lid on the recommended economic stimulus. Summers talks about a New Normal of slow economic growth, without any apparent self-knowledge about his role in bringing it about. Before the publication of their noted paper with the spreadsheet errors, Reinhart and Rogoff met privately in the winter of 2009-10 with Republican Senators to push the idea of austerity, a move which may have contributed to the advent of the Tea Party later that year. Keynes talked about the ideas of dead economists. We have to be on our guard for the ideas of living economists, as well.
Posted by: Min | January 15, 2017 at 05:13 PM