What If We Ask If Economics Caused The Financial Crisis?

Mainstream economics people like Krugman and Wren-Lewis seem to think the strong charge against their profession wrt the 2007/8 financial crisis is that economics failed to predict the coming storm. 

But what if economics caused the financial crisis? 

 

Fact: Economics Does Not Provide Forecasts Tim Hartford

Fact: Economics Does Not Know What Causes Recessions Noah Smith

Both Smith and Krugman show hints that they see the revolution coming in the form of agent based models. Smith mentions it in the article above, Krugman mentions it here:

Now maybe, someday, someone will find a way to do something truly new — integrate neuroscience into economics for real, not as a marginal research topic, or turn agent-based models into a useful tool. I’m for it! But merely noting the foolishness of some economists and calling for a new paradigm in the abstract won’t get us there.

All of this is fine, they are doing their best. But what if their best is a net harm to society?

Below follows a back and forth I had on this subject in the comments thread for Worthwhile Canadian Initiative.

My point is that if you strip away all the discourse about theory, policy makers would be forced to make their choices based on the correlations of history. Would such people know the truth about cause and effect? Who cares? Certainly not policy makers, nor their subjects. The question is rather, would their decisions have the desired effect?

Imagine a medical experiment where everyone starts out with a a virus induced cold they caught on the same day. The control group makes no change, but the experimental group, relying on correct theory about germs an the immune system, takes an anti-biotic. Both groups recover at the exact same rate. Over time, however, this misuse of antibiotics leads to a global disaster as antibiotic resistant bacteria kill 30% of the population.

You can look at the experiment and say that without theory we can't understand the cause and effect involved with disease. I look at the experiment and say, theory didn't help anyone get over a cold any faster and it ultimately lead to global catastrophe. Keep your theory in a tower, please. The rest of us will muddle along just fine with correlation and induction.

Nick Rowe (blog author) replies: Thornton: economists aren't stupid. We have thought about these questions. If we could do experiments, it would be easy. Give me 100 countries, I will toss a coin to divide them into two groups, and will raise interest rates in one and cut them in the other, then wait a couple of decades. If my theory is right, the first group will suffer a deflationary recession, and the second group will suffer hyperinflation. We can test my theory easily that way, and learn a helluva lot about economics. But it would never get past the Research Ethics Board. Countries don't like having their monetary policy determined by the toss of a coin. In any sensible central bank, interest rates are only changed to offset what they see as a shock, so we can never disentangle the effect of the interest rate change from the effect of the shock. Some economists do search through the history, or write history books (Milton Friedman's Monetary History of the US for example) trying to hunt down "natural experiments" where policy changed for what looks like some "random" reason. There is a whole branch of economics, called "econometrics", which tries to help us "muddle along...with correlation and induction". But the speed of my car is correlated with the position of the speedometer needle. If I grab the needle and move it, will that cause my car to speed up? Those econometricians have even invented "causality tests" which try to disentangle cause and effect. But they know their tests aren't perfect, because their tests say that people carrying umbrellas causes rain.

Doctors are very smart, too. But it turns out that eating cholesterol has nothing at all to do with blood cholesterol. A generation and a half was taught that eggs are bad for you and skim milk is good for you. The exact opposite is true.

But more importantly, there's another point that I am making. Why is the question posed as if "doing economics" is either useless or beneficial. The third possibility is, logically, that the world is worse off as a result of the existence of economics. Krugman obviously is aware of a scary third possibility, which is why he is at such pains to demonstrate the difference between what he calls "textbook economics" and... er... things that were demonstrably wrong. SWL has joined this project. Yet, to the lay outsider, it looks like there is no principled distinction that policy makers could have seen before the crisis.

I think the kerfuffle over Larry Summers and the Fed is instructive. Us dumb non-economists could plainly see that his support for deregulation was part of the cause if the crisis. Interestingly, no one (with the possible exception of DeLong, whose comments on the subject were totally unintelligible) defended him on the basis that he was simply applying the standard textbook economic wisdom of the time. But as near as I can tell, that is exactly right. The smartest guy in the room applying the state of the art wisdom in the field took deliberate steps to enact policies that directly led to the immiseration of millions of people.

I think the comparison to the physics of weather is an apt one. The thing is, back before super computers and complexity theory, meteorologists weren't walking the halls of power advising that the best way to protect rural Americans from severe weather was to collect them into concentrated locations and give them cheap portable shelter (ie, trailer parks).

NR: Thornton: "Us dumb non-economists could plainly see that his support for deregulation was part of the cause if the crisis." A very narrowly American perspective. Canadian banks have been much more stable than US banks for a very long time. But it is not at all clear to me that Canadian banks have been more tightly regulated than US banks. If anything, they have been less tightly regulated. No restrictions on multi-branch banking, for example. No legal reserve requirements for the last 20 years. Differently regulated maybe, but not more regulated. I am old enough to remember when many educated people thought that centrally-planned economies would obviously do better then every man for himself. They sneered at economists' talk about invisible hands. Governments will make economic policy one way or another. Someone will always be giving them advice. Economics won't go away. Keynes said something apt about so-called practical men. But this is now way off-topic. So let's let it drop.

Jacques René Giguère adds: Nick: my trolling quotient being rather low, permit me one slightly O/T on bank stability: " No restrictions on multi-branch banking, for example. " Meaning that a bad mortgage in a faraway province stay on your book instead of being unloaded. May induce slightly induce more prudence. I'll try to find the link but last year, the Atlanta Fed did a study on why Canadian and Australian banks withstood the crisis better, Fascinating for surprising reasons (among others, a wish to diminish lower and middle classes influence on the power structure of a colony). IIRC, Mark Thoma linked to it in mid-april 2013 and there was a mention in The Economist.

NR: Jacques Rene; you're allowed! A month ago, David Price from the Richmond Fed emailed me this interesting article comparing US and Canadian banking stability PDF. I was in the UK, and my brain was fried, so I never got around to doing a post on it. The money quote: "One might suspect that it’s because Canadian financial institutions tend to be more tightly regulated; they have higher capital requirements, greater leverage restrictions, and fewer off-balance sheet activities. But Canada’s financial system was largely unsupervised until the late 1980s. In a period in which both Canada and the United States had virtually no official supervision or regulation of bank risk-taking — from the 1830s to the advent of the Fed in 1913 — America experienced no fewer than eight systemic banking crises, while Canada had only two short-lived episodes in the 1830s relating to problems here. That suggests regulation alone can’t explain Canada’s stability."

I think this is the money quote:

>>Nowhere did Canada’s structural and regulatory
differences manifest themselves more clearly than in mortgage
finance. Canadian banks tend to hold on to mortgages
rather than selling them to investors. Fewer than a third of
Canadian mortgages were securitized before the financial
crisis, compared to almost two-thirds of mortgages in the
United States. Some have argued that this, combined with
tight regulatory standards, gives Canadian banks stronger
incentive to make those mortgages safe. Fewer than 3 percent
of Canadian mortgages were classified as subprime
before the crisis, compared with 15 percent here. In Canada,
banks can’t offer loans with less than 5 percent down, and
the mortgage must be insured if the borrower puts less than
20 percent down. Mortgage insurance is available, moreover,
only if the household’s total debt service is less than 40 percent
of gross household income. Not only did Canada have a
much smaller housing boom than us, but its mortgage delinquencies
barely rose above the historical average of less than
1 percent. At the peak, 11 percent of American mortgages
were more than 30 days overdue.

Which is another way of saying: housing finance is better regulated in Canada.

But more importantly, I'm not just talking about the repeal of Glass-Steagal. I'm neither an insider, nor an economist, so my understanding may be wrong. But it seems to me that the most telling event of the crisis was the bailout of AIG. Why did an insurance company need a bailout? Because otherwise General Electric would fail. Why did GE have anything to do with anything? What sort of insurance was this? Isn't the answer to those questions: textbook economics says that the more "complete" a market is, the more stable it will be? Credit default swaps and all the rest of the totally unregulated explosion of derivatives were praised as "innovation" by Alan Greenspan. At the time I thought this was Ayn Rand influenced nonsense. But now I think it was just run-of-the-mill economics.

I guess what I am driving at is this:
What guidance did the field of economics provide to the well intentioned policy maker in 1995 who wanted to know if derivatives should be allowed to proliferate, linking risk across banks, non-banks, and non-financial entities? Isn't it the case that economics had a more or less clear answer: it's a good thing that makes the system more stable? Is so, is there a principle that could be applied in retrospect that would have told us to ignore that advice, a principle that could guide us in the future?

Because if there isn't, it seems to me that the field should simply refrain from comment on policy. Plenty of academic fields are like that.