..Your Majesty, economists did something even better than predict the crisis. We correctly predicted that we would not be able to predict it
Regarding the Queen's famous challenge to economists, (and Geoff Hodgson's insightful response.pdf), I've been considering the role of forecasting. So has Sandy Ikeda, who asks a typically insightful and humble question:
Who, if anyone, firmly within the Austrian camp — let’s say associated with NYU, GMU, WVU or current members of the SDAE — called this latest boom and bust? I certainly didn’t
There are plenty of answers in the comments section. I think that all public Austrian economists who are now claiming that Austrian theory both explains (i) what caused the credit crunch; (ii) why orthodox policy responses are wrong-headed; do have a responsibility to respond to this issue. And we can answer it in two ways.
Firstly, as Sandy suggests, where is the textual evidence that this was discussed ex-ante? The power of blogging is that there's no excuses about academic publications having lags and/or a bias against contemporary relevance - if you weren't writing about this before 2007 then you didn't foresee it.
Secondly, students have every right to expect us not only to have predicted it, but to have prospered from it. I'm not suggesting that economists should make their family finances public, but we could be more transparent about how our personal investment strategies tie into our proclaimed wisdom. If we did see it coming, what concrete action did we take to benefit from this materially?
So the questions I think all economists (academic and commentators) should answer, and my personal responses:
1. Is there any evidence that you foresaw the credit crunch?
"I took one of the student research assistants with me to Chatham House yesterday, for a lecture by 2004 Nobel Prize winner Finn Kydland on "The Dynamics of Business Cycles and Monetary Policy - Links and Drivers".
Key point was that "residential construction" is the clearest driver of the business cycle (with a 3-4 quarter lead) and "consumer electricals" is also a strong driver (with a 2 quarter lead). I think this is very strong evidence that the current cycle is partly being fuelled by the housing market. Add to this the evidence that interest rates have been kept artificially low recently (even The Economist has questioned whether a little deflation would be a good thing) and will inevitably rise more in the future.
Add also the amount of debt home owners are taking on who enter the market (i.e. "marginal homeowners" and therefore how exposed they are to a rise in rates....
There's a very clear narrative ...- marginal investers tempted in when there's cheap money about, inevitable bust will occur"
I also found an unpublished project proposal that was written in April 2007:
"If the adverse selection argument is true, we’d expect the downturns in subprime lenders to become especially prevalent, and evidence from America suggests that this is happening. According to Morgan Stanley, late payments rose from 7% in 2003 to 12.6% last Autumn, and HSBC’s bad-debt costs rose by 36% to over $10billion in 2006."
Then of course there's The Filter^. Here are a few quotes about this (note I couldn't find any that contradicted this view, so this isn't a case of selective evidence):
- "the question isn't "will the housing market slow down?" because it will. We have enough economic knowledge to know that the current growth rates are unsustainable...With cheap access to capital, (via low interest rates) and a "bricks and morter" reaction to the tech crash, house prices have largely been inflated by people buying second homes to let. This is why rents are so low at the moment. Interest rates have gone up recently, and the more they do so the less profitable these investments are, making it more of an incentive to sell up... So we know it will end, but we're not sure when. How will it end? Here, I'd claim 'self-fulfilling prophecy' - if people expect a crash, as soon as prices dip they'll put theirs up on the market to cash in, and in doing so produce a crash... Dare I forecast? I think it's the right time to sell." April 2004
- "when house prices begin to really fall, and people lose a lot of wealth, I am sure there’ll be much criticism of “capitalism” or “the market”. Be very warned that the real reason behind the house price bubble is the engineering of those too stubborn and controlling to leave free the complex economic ecosystem" July 2005
- "ABC is on the rise: trust me, i'm on it." June 2006
- September 2006 I posted a round up of economic commentators that used Austrian theory
- "Central Bank Independence isn't a binary issue; contemporary Central Bankers have yet to be properly tested; there's a lot more credit available than blunt proxies illustrate." March 2007
- "it seems sensible to assume that the housing market is frothing (rather than it's operating beautifully and the excess credit is manifesting itself in a hitherto unspotted part of the economy)... When interest rates rise - as they surely must - house prices will cease surging, but it's up to the next Chancellor how this process is managed. The economy is an airbed: Brown merely squeezed on the Dot Com bubble to shift the air pocket to house prices. At some point the charade has to end and the valve released. We've been living beyond our means, and the crunch is coming. When that happens, remember who's to blame." April 2007
2. Did you put your money where your mouth is?
- Faith sold her house in 2004, we returned to the UK in 2006 and rented rather than bought
- Put money into cash ISAs and online savings account so that we had liquid assets
What I didn't foresee was the policy responses to this. I was expecting house prices to fall by more than they have, and for the value of my savings to be higher than they were (we've recently bought somewhere). But as we know, the government's response has been to bailout reckless borrowers at the expense of prudent savers.
One very important caveat - my motivation is not to create money. In this regard my investment strategy is mainly to protect the wealth I create from being a Professor, rather than to advance that wealth. In this regard I am an observer of capital markets rather than a participant, and this distinction is, for me, key. But the bottom line here is don't trust an economist, trust yourself. And if you take the time to read these three books, I'm sure you'll understand the pull of Austrian analysis:
- The Failure of the New Economics(.pdf), by Henry Hazlitt (1959) - or buy from Amazon here.
- Prices and Production(.pdf), by Friedrich Hayek (written 1929-1937) - or buy from Amazon here.
- What Has Government Done to Our Money?(.pdf), by Murray Rothbard (1980) - or buy from Amazon here.
The response to my bleg has been very helpful and quite heartening, and I thank everyone who responded. Based on “accuracy and distance,” however, the winner appears to be Fred Foldvary, who in 1997(!) hits it on the nose:
“the next major bust, if there is no major interruption such as a global war, will be around 2008.”
(American Journal of Economics and Sociology 56(4): 521-41, quote at p. 538.) Thanks to Dan Klein for the tip and the cite.