How Economists Failed Us, Failed the Queen of England, and Keep Fooling Themselves

I read in astonishment an article on the July 26th UK’s Observer about a letter a group of economists sent to the Queen of England to answer a question she had asked during a visit to the London School of Economics.

It turns out that during this visit, while being no doubt showered with economists’ parlance and shown numerous graphs explaining -of course after the fact- the causes of the credit crisis, she asked the most sensible question yet to be put to an economist since the near-collapse of the entire financial world as we know it: Why didn’t you predict this was coming?

The letter, signed by a rank of experts from the Bank of England, academia, the London City, regulatory agencies, and businesses, makes a heroic effort to not point fingers, fails to put blame on anybody in particular, and can best be summarized as a less-than-satisfying “we’re sorry, but will try to do better next time”.

One of the economists’ excuses for this “failure of the collective imagination”, as they put it, is that some of them did foresee the crisis, they just failed to predict “the exact form that it would take, the timing of its onset and [its] ferocity”. It seems to me that this isn’t of much help. I can predict right now that in the next 10 years there’s going to be an economic crisis. I just can’t tell you where in the world it’s going to happen, what’s going to cause it, and how serious it will be. Surely you don’t need to go through Economics Graduate School to come up with this!

The other justifications -there were local warnings but we failed to identify the systemic risks, risk management was left to individual banks but they didn’t see the bigger picture, we believed that “financial wizards” had come up with new ways of managing risks, authorities didn’t want to burst the “feel-good” bubble, we trusted we’d be able to avert a recession once the bubbles bursted- sound equally lame and insufficient and, most of all, make you question the role of regulatory agencies.

The letter reminded me of two books I read recently, George Soros’ The Crash of 2008 and What it Means and Nassim Taleb’s The Black Swan: The Impact of the Highly Improbable, which, although very different from each other, share their view on the role and limitations of modern economics.

Both books’ authors agree that modern economics has gone too far in its attempt to separate itself from the rest of the social sciences. In the process of building ever more complex mathematical models based on untenable assumptions of rationality, economics has ended up unable to foresee drastic deviations from the long-term equilibrium such as the one represented by the current crisis -arguably the most important events economics should be able to predict in advance.

This points seems to be partly acknowledged in the letter when the economists say that “[the misguided views that traditional risk measures did not apply any more] were abetted by financial and economic models that were very good at predicting the short-term and small risks, but few were equipped to say what would happen when things went wrong as they have”.

The letter ends trying to give reassurance that the events of the past year have shocked economists and regulators in general into action. The signers intend to “host [a] seminar” were they’ll try to come up with a new “horizon-scanning capability” so that the Queen’s question doesn’t need to be asked again.

How much hope is there that they will manage to predict and react to the next big economic crisis in advance? In my opinion, very little. I’d have a different view if this were the first time economists have been surprised by a crisis of devastating consequences and huge reach. Unfortunately, it isn’t. I can think of at least one example in each one of the past four decades, two just from the beginning of the millennium. I bet that after every one of those they claimed they wouldn’t be caught up unawares again, and yet they eventually did -they let bubbles grow, exotic and difficult to regulate financial products spread, households over-invest in the stock market, over-spend in housing, and under-save without warning, they tried to predict new dangers using the paradigms of the past.

I hope more than anything that I’m wrong but, just in case, I’m spending time learning to take care of my finances, because I don’t trust economists -specially those in regulatory roles- to be able to do that for me.