The Times can barely conceal its "how stupid were they" glee.
The officials laughed about the cars that builders were offering as signing bonuses, and about efforts to make empty homes look occupied. ...But the officials...gave little credence to the possibility that the faltering housing market would weigh on the broader economy,... Instead they continued to tell one another throughout 2006 that the greatest danger was inflation...Justin Wolfers says the lack of foresight is "embarrassing,"
“It’s embarrassing for the Fed,” said Justin Wolfers, an economics professor at the University of Pennsylvania. “You see an awareness that the housing market is starting to crumble, and you see a lack of awareness of the connection between the housing market and financial markets.”
“It’s also embarrassing for economics,” he continued. “My strong guess is that if we had a transcript of any other economist, there would be at least as much fodder.”(I hope for Justin's sake that his quotes were as usual mangled and taken out of context.)
The Journal piles on. Cassandras were ignored: "A handful of Fed officials warned of trouble brewing." The other "Fed officials were expecting a manageable slowdown in the housing sector, with little damage to the financial system or broader economy." And heavens, they even had "praise for outgoing Fed Chairman Alan Greenspan."
Well, that was fun. But what's the point, dear Times? We just need to put "smarter" people in charge and all will be well?
The real lesson is this: The smartest people in the room didn't -- couldn't -- see it coming. The smartest people in the room won't see the next one coming either.
Nobody can systematically predict the financial future a lot better. If they could, they'd be rich enough to bail out the National Debt.
Sure, some people warned of this event. But half of them won't see the next one. The other half have already predicted 5 more crises that never happened. The project "we'll just find someone a lot smarter or wiser than Ben Bernanke" is hopeless!
It's not embarrassing to my economics. The main prediction of market efficiency is precisely that nobody can systematically see market movements and bank runs ahead of time. Efficient markets are not clairvoyant markets. That prediction seems rather brilliantly confirmed!
This matters. We have doubled down on the idea that we can appoint All Powerful Regulators to presciently spot "bubbles" and "imbalances" before private forecasters and the harsh judgment of financial markets do so, and then regulate away the risks. This strategy has already failed at least three times, after the crisis: The SEC didn't notice Bernie Madoff; the CFTC didn't stop Jon Corzine, and the entire European bank regulatory apparatus failed to notice that sovereign debt might be risky.
This story is embarrassing, yes. But it's most embarrassing for the Times and other believers in the idea of clairvoyant, all-powerful discretionary regulators. It's not at all embarrassing if you think Fed officials are as human as the rest of us -- and that safety comes from better rules of the game, not finding just the right soothsayer to run the show.
I agree that a bubble in general must be difficult enough to spot such that only a minority of forecasters can correctly identify it, that is true by definition, otherwise the bubble wouldn't exist because the majority of investors would be aware of the value of the asset and price it correctly. I disagree however that the Fed COULDN'T have predicted it, just that it would have been statistically unlikely. The information was there however that clearly showed housing backed assets to be overpriced.
ReplyDeleteAnd if you go to Jim Hamilton's blog, you can read his June 2005 explanation of why it was not a bubble:
Deletehttp://www.econbrowser.com/archives/2005/06/what_is_a_bubbl.html
And Hamilton, is a very smart guy.
Could the Fed have called it right? Sure a blind squirrel find and acorn every once in a while.But, the real issue is that the Fed, like all governmental bodies, cannot provide its analysts and governors with the appropriate incentives to be right about such things. And it will always be that way.
Are there any economists saying that we need someone besides Bernanke?
ReplyDeleteI think it's a bunch of talk about how stupid people think Bernanke is, followed by the inevitable realization that he's one of our best. However, I think you're right. No one is really saying "DOWN WITH BERNANKE"; They just insult him, as well as anyone who didn't have the convenience of seeing the crash in hindsight, and make vague implications that he's incompetent, and perhaps replaceable. Nothing will materialize, obviously. Few (any?) would have done a better job.
DeletePerhaps I am completely wrong, but I believe that Economics, as science is still underdeveloped for political use and this is the cause of several problems. Let me give a couple of examples: I have read somewhere BETWEEN 50% AND 70% of any GDP estimation (Hsieh,C.T; Klenow,P.J. "Development Accounting", AEJ Macroeconomics, 2, 2010). Not to talk about CES production functions ...
ReplyDeleteThere is also another interesting paper that says that in terms of results, our forecasting models are as good as a monkey aleatorily choosing results. In my personal experience, those things are Taboo in the academy.
I mean, it seems to me that we haven't enough tecnical knowldge in the field to actually adress everyday questions. What about predicting the unpredictable?
Prof. Cochrane, the reason I am writing this comment is that I would love to hear your opinion on the issue.
Thanks,
Sorry, I went to reread my post and saw that it needs correction:
DeletePerhaps I am completely wrong, but I believe that Economics, as science is still underdeveloped for political use and this is the cause of several problems.
Let me give a couple of examples: I have read somewhere that a arbitrary value called TFP (Total Factors Productivity) represents BETWEEN 50% AND 70% of any GDP estimation (Hsieh,C.T; Klenow,P.J. "Development Accounting", AEJ Macroeconomics, 2, 2010). Not to talk about CES production functions ...
There is also another interesting paper that says that in terms of results, our forecasting models are as good as a monkey aleatorily choosing results. In my personal experience, those things are Taboo in the academy.
I mean, it seems to me that we haven't enough tecnical knowldge in the field to actually adress everyday questions. What about predicting the unpredictable?
Prof. Cochrane, the reason I am writing this comment is that I would love to hear your opinion on the issue.
Thanks,
On the one hand they took take credit for the great job they were doing - great moderation. Then when it turns to crap it's 'who could have known'.
ReplyDeleteIt's not that they didn't predict the crisis it's that they had no clue! Why, because markets are always right. Until they're not.
What we need is more automated rules and regulations. Humans are not very good at systematic predictions, but they are good at designing computer programs that make those predictions
ReplyDeleteExample: high frequency trading
In this case, a rule would automatically estimate the likelihood of a spillover from housing and recommend certain actions if likelihood greater than x
Note that many funds that trade systematically actually do quite well over long periods
I'm so friggin' happy Cochrane is (1) blogging and (2) doing so regularly.
ReplyDeleteI find the lack of introspection disturbing.
ReplyDeleteInstead of saying "that's the beauty of my school of thought! Market efficiency says I can't predict anything, therefore I was right to be wrong", you should be saying "we made a major mistake that destroyed the economy, how can we make sure it doesn't happen again".
This crisis was actually easy to see coming - calculating simple ratios such as median house price / median household income and comparing them to historical averages would have shown the situation was seriously wrong, and people let the imbalances build up exactly because they were blinded by the illusion of "market efficiency". So basically the only people who didn't see this crisis coming were the "market efficiency" believers, while those who didn't believe in it, such as Krugman or Roubini, could easily see it coming.
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ReplyDeleteNot that I disagree with you John, but you use way too many exclamation points.
ReplyDeletehttp://en.wikipedia.org/wiki/Exclamation_mark#Usage
What about the argument that they can't be faulted for their beliefs in 2006, but can be faulted for their inept handling of the recession when it began? I think one can make that point, and then argue furthermore that we will always have a fallible Fed whose discretion is unreliable and then propose reforms of that institution. Milton Friedman favored a rule regarding the growth of M2, Scott Sumner favors targeting futures markets on NGDP, and others think a system of free-banking will ensure that the supply of money is appropriate for the demand.
ReplyDelete"So basically the only people who didn't see this crisis coming were the "market efficiency" believers, while those who didn't believe in it, such as Krugman or Roubini, could easily see it coming."
ReplyDeleteSo why didn't they?
Anonymous, regarding making predictions on future housing prices, is that true around the world or just the U.S? Scott Sumner argued that in most countries real estate did not follow Shiller-type predictions (although as I pointed out in the comments, Shiller himself hedged rather than outright saying housing would crash in his book).
ReplyDeleteJC, What do you think would happen if the Federal Reserve released a statement saying, "we are putting the breaks on the economy"?
ReplyDeleteI suspect it would trigger a recession, mild in comparison to the one we are in now, but how were they suppose to know that at the time? I've read good papers from the Romer's on how the Federal Reserve could be responsible for some of the U.S. recessions and I agree in general.
The Federal Reserve is in a position where they are, "damned if they do, damned if they don't".
In any case, the real problem is the lack of insight into what the financial sectors was doing with derivatives.
It really shouldn't be that surprising that they didn't catch this.
The Fed chose to fight global commodities inflation through US monetary policy. That did put a torpedo into the USA economy at precisely the wrong time, and dented commodities prices for a few months. Commodities have recovered, but not the USA economy.
ReplyDeleteI hope lesson learned.
The way forward is found in Market Monetarism. The option to Market Monetarism is Theo-Monetarism, or a primitive belief that capping inflation alone will result in prosperity. Genuflecting to gold and the stagnant value of paper money are the marks of Theo-Monetarists.
That have tried Theo-Monetarism in Japan for 20 years with catastrophic results. Stocks down 75 percent, and property down 80 percent, Industrial production down by 20 percent, and the slide continues.
BTW, USA commercial property markets dumped as hard as the residential markets---despite dominance by institutional lenders and investors, and no Fannie/Freddie. That strongly suggests a powerful force crushed real estate in the USA--like the Fed over tightening. The Fed is still too tight.
Central bankers have a peevish fixation on inflation---and thus are dangerous to economic prosperity.