I’m fascinated by the failure of economists to foresee the meltdown. Brad DeLong lists the things his failed to see coming, which is an important lesson for scenario thinkers about the kinds of little and unexpected things that turn out to have huge consequences.
Calculated Risk issues an invitation:
Calculated Risk: Hoocoodanode?: Earlier today, I saw Greg “Bush economist” Mankiw was a little touchy about a Krugman blog comment. My reaction was that Mankiw has some explaining to do. A key embarrassment for the economics profession in general, and Bush economists Greg Mankiw and Eddie Lazear in particular, is how they missed the biggest economic story of our times…. This was a typical response from the right (this is from a post by Professor Arnold Kling) in August 2006:
Apparently, the echo chamber of left-wing macro pundits has pronounced a recession to be imminent. For example, Nouriel Roubini writes, “Given the recent flow of dismal economic indicators, I now believe that the odds of a U.S. recession by year end have increased from 50% to 70%.” For these pundits, the most dismal indicator is that we have a Republican Administration. They have been gloomy for six years now…
Sure Roubini was early (I thought so at the time), but show me someone who has been more right! And this brings me to Krugman’s column: Lest We Forget
… Why did so many observers dismiss the obvious signs of a housing bubble, even though the 1990s dot-com bubble was fresh in our memories? Why did so many people insist that our financial system was “resilient,” as Alan Greenspan put it, when in 1998 the collapse of a single hedge fund, Long-Term Capital Management, temporarily paralyzed credit markets around the world? Why did almost everyone believe in the omnipotence of the Federal Reserve when its counterpart, the Bank of Japan, spent a decade trying and failing to jump-start a stalled economy?
One answer to these questions is that nobody likes a party pooper…. There’s also another reason the economic policy establishment failed to see the current crisis coming. The crises of the 1990s and the early years of this decade should have been seen as dire omens, as intimations of still worse troubles to come. But everyone was too busy celebrating our success in getting through those crises to notice…
[I]n addition to looking forward, I think certain economists need to do some serious soul searching. Instead of leaving it to us to guess why their analysis was so flawed, I believe the time has come for Mankiw, Kling and many other economists to write a post titled “Why I was wrong”.
Let me say what things I was “expecting,” in the sense of anticipating that it was they were both likely enough and serious enough that public policymakers should be paying significant attention to guarding the risks that it would create:
(1) A collapse of the dollar produced by a panic flight by investors who recognized the long-term consequences of the U.S. trade deficit.
(2) A fall back of housing prices halfway from their peak to pre-2000 normal price-rental ratios.
I was not expecting (2) plus:
(3) the discovery that banks and mortgage companies had made no provision for how the loans they made would be renegotiated or serviced in the event of a housing-price downturn.
(4) the discovery that the rating agencies had failed in their assessment of lower-tail risk to make the standard analytical judgment: that when things get really bad all correlations go to one.
(5) the fact that highly-leveraged banks working on the originate-and-distribute model of mortgage securitization had originated but had not distributed: that they had held on to much too much of the risks that they were supposed to find other people to handle.
(6) the panic flight from all risky assets–not just mortgages–upon the discovery of the problems in the mortgage market.
(7) the engagement in regulatory arbitrage which had left major banks even more highly leveraged than I had thought possible.
(8) the failure of highly-leveraged financial institutions to have backup plans for recapitalization in place in the case of a major financial crisis.
(9) the Bush administration’s sticking to a private-sector solution for the crisis for months after it had become clear that such a solution was no longer viable.
We could have interrupted this chain that has gotten us here at any of a number of places. And I still am trying to figure out why we did not.