"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."--Quoted in NYT.
In 2006 the experts running the Fed clearly knew that the housing bubble was imploding. What they lacked were four further crucial ingredients: (i) reliable data on what we now call systemic risk; (ii) a theoretical or institutional framework that makes folk question their own ignorance [rather than be self-congratulatory]; (iii) a historical sense of what happens in the aftermath of a bubble; (iv) an institutional framework for a more robust system.
Of the four only (iii) can be relatively easily corrected: return economic history and history of economics to (a more central place in) the graduate curriculum of economists. In fact, Chairman Bernanke, a scholar of the 1930s depression, proves to be exemplary; at the time he "appears as the most consistent voice of warning that problems in the housing market could have broader consequences." Even though terrible mistakes continue to be made during the subsequent crisis (including the ECB's willingness to keep insolvent institutions in business), Bernanke's actions also almost certainly prevented a complete meltdown of the system, especially -- to note an episode that has gone under most radar-screens -- by guaranteeing money market funds (see also here).
But even if graduate education of our experts were successfully reformed (no guarantee of that) this leaves three terrible problems. Now on (iv) most economists and regulators are inclined to think that what's needed is to make sure that risks gets adequately priced in the market and internalized by the financial firms that create it. The idea is that then financial firms/agents will not socialize the costs while they pocket the trading gains. I believe this approach is hopeless because of the first two problems (i) and (ii). In particular, even if we assume competent and honorable experts at the regulatory level, private entities will continue to have lots of incentives to hide relevant data. More important, there is probably no way that one can have real-time access to all the relevant systemic risks that are being generated constantly in the market place. This is not to deny that one can create incentives such that data and information is voluntarily shared in a useful way. So, even though a much better financial cock-pit (a term I learned from J-P Fouque) at the FED is desirable, it will probably be running on out of date information.
Now, in general markets are very good discovery engines when we are dealing with dispersed and complex phenomena. But here we are dealing with a case where markets are part of the problem and where the standard solution (internalize costs) is decidedly unpromising because we have no mechanism by which unknown future costs are reasonably priced here. [Elsewhere I have proposed an alternative approach focused on a learning ethos and, for example, here. But it seems business-as-usual is prevailing.] So, until a financial crisis precipitates a full-scale political crisis & revolutionary situation (and we might experience this in the Eurozone in 2012) we'll probably muddle through with small scale changes to existing institutions; the tacit understanding is that if some financial crisis cannot be contained we will let the central banks inflate away the problem.
Meanwhile, this leaves problem (ii): we lack an institutional framework in which our policy experts can systematically discern their lack of knowledge. This is, in part, due to a problem first diagnosed, I think, by Popper. Much social science is confirmatory in character; it looks for statistical evidence to confirm theories. But absent very reliable background theory this whole approach leaves us in a terrible position on the extent of our ignorance. That is to say, expert over-confidence is a byproduct of the way social science attains results. I never thought I would say this, but now -- more than ever -- we need a Popperian spirit to help us re-think the structure of policy science.
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