Applying imagination to the financial crisis

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.

Comments

[Jim]

Having skimmed it (constraints of time, sorry), it does seem overly speculative, and features quite a few strong claims thrown in there without much supporting argument or evidence, such as 'A primary cause of the Great Depression was that markets were not allowed to clear'. Maybe it was, but why should I believe you? I would also suggest leaving out stuff like the 'Ron Paul saw it all coming!' bit as it makes it all look more like a politicised tract.

I'm also not completely clear what we're meant to think of the 'scenario-building' approach outlined in the last section. Are these macroeconomic models you're talking about? If they are just generalized descriptive scenarios, will the outcomes really be clear enough to support or undermine any theories?

More generally, and this might not be your precise intention in writing the paper, does this approach really get at the problems within economics in the run-up to the crisis? Maybe you'd say that Austrian economists predicted it to some extent, but then Dean Baker and others on the left could make similar claims. Overall, though, the profession seems to have really dropped the ball. Was this a failure of ideas, or incentives, or just a human inability or unwillingness to adequately conceptualise possibly future crises?

[aje]

Was this a failure of ideas, or incentives, or just a human inability or unwillingness to adequately conceptualise possibly future crises?

I'd say a mixture of all three. Ultimately we can't predict the future, so there's always going to be a large amount of ignorance. I think ideas compound this, because the majority of economists were focusing on the most likely event, rather than thinking broadly about the impact of all possible events (i.e. it doesn't matter whether the black swan is a 20 sigma event, we should still think about it and monitor whether it's emerging). The incentives don't help either - almost all macroeconomists are paid by the government and it takes genuine outsiders (either academic outcasts, maverick politicians or journalists) to say anything remotely controversial/speculative/interesting. One of the key messages I've tried to get across throughout the crisis is that we should be talking about monetary regimes not policy. Needless to say I'd earn more money and have a better professional reputation if got into the debate about the appropriate level of QE, instead of refusing to answer that question and argue instead for the abolition of central banking...(!)

Thanks for reading it though. I take your points. I don't intend for it to be partisan in any way, and if I haven't given full due to people on the left who also saw it coming that's something i'd want to fix if/when it actually gets published somewhere.

[Leigh Caldwell]

Thanks for the link, Anthony: I didn't think your original comment was all that rude! A few months of blogging is all it takes to develop a thick skin.

I thought your paper was very interesting though I agree with some of Jim's criticisms. My response is at http://www.knowingandmaking.com/2009/08/three-kinds-of-economic-story.html

[Debt Rescue]

if we predict the financial crisis is to be worst in future , this is shown with the hike prices and economic down fall .