Whether or not economists could, or should, have predicted the financial crisis, there is an unprecedented urgency and demand for the profession to make itself a little more useful than it currently is. This working paper argues that economists have two main tools at their disposal, both of which are shockingly under-utilized. The first is counterfactual analysis - the ability to construct alternative histories to robustly assess what has transpired to be. The second is scenario building - the creation of alternative futures to interpret and respond to what is to come.
This is the abstract for a working paper of mine published by the Mercatus Center - you can download it here. Back in February I rather rudely dismissed Leigh Caldwell's attempt at counterfactual reasononing, and asked the following: "Has anybody provided a coherent and rigorous account of what might have happened without large-scale intervention?"
The paper above is based on talks I've given at the University of Oxford in February and for the Helsinki School of Economics in April, and is my attempt to start a discussion. It's highly speculative and I welcome feedback.
Update: Tyler Cowen asks, "I would be curious to hear your counterfactual version of how matters would have proceeded, without the financial bailouts". My paper above draws heavily on Tyler's own counterfactuals (plus the speculative work from Jeff Hummel).
Update II: Bryan Caplan asks: "Suppose there had been no bail-outs, and everything that's happened
since happened anyway. How many pundits would claim that the world we
now see around us was indeed the foretold Armageddon?"
Update III: Leigh Caldwell answers,
However one principle of science is that you can only disprove a
theory, never prove one. It would be more scientifically convincing to
tell us how to spot that the scenario is not happening.
There's a distinction between the positivist hegemony and "science". I accept that the vast majority of scientists are fully wedded to positivism but (a) I'm not; (b) non-positivist science isn't necessarily "faith". The distinction between faith and science is a modernist construct, so if you reject modernism (as I do) we're talking about different things. I don't accept that controlled experiments are the only way to learn about causal processes, and I think that the importation of scientific techniques associated with the harder sciences into economics is perverse. The main point of the paper is to get us away from making predictions *and* falsifiable statements subject to refutation. So there's a whole heap of methodological issues bubbling under the surface.
By this standard, a couple of the examples in this paper are suspect... I can't for the life of me see how corporation tax causes wage
rigidity, nor how it has any major impact on corporate flexibility.
Raising the retirement age has an equally vague connection with the
intended outcome.
Leigh makes a couple of criticisms such as the one above. They are considered, insightful, and to that end I don't feel a need to quibble. To clarify the above the general point is to look at policies that make businesses more "adaptable". Admittedly this is vague but I'm claiming that a reduction in corporation tax and increase in the retirement age would help businesses cope with labour markets that are in an adjustment phase. I'm delighted that someone is playing along with the construction of scenarios, and Leigh's comments on the Great Depression are well worth reading.
