Monday, September 21, 2009

Elaboration of failure to predict crisis

I'd have to agree with MR:

Some economists are trying to get macroeconomics off the hook by arguing that by their very nature crises are unpredictable. Thus David Levine aggressively argues that "our models don't just fail to predict the timing of financial crises - they say that we cannot." ...

If you play Russian Roulette with 1 bullet and 100 chambers in your pistol, I can't predict when the crisis will occur. If you play with 10 bullets, I still can't predict when the crisis will occur but I can say with certainty that the risk has increased by a factor of ten. Analogously, nothing in modern economics makes it theoretically impossible to forecast that greater leverage and higher than normal price to rental rates, to name just two possibilities, increase the probability of crisis. Nor does modern theory make it theoretically impossible to forecast that conditions are such that if a crisis does occur it will be a big one. ...

Thus the "we could not have predicted the crisis even in theory" argument is a weak defense--even with rational-actor, rational-expectations models there are plenty of senses in which economists could have better predicted the crisis and, although this is yet to be seen, perhaps they could and will do even better with other sorts of models.

David Levine's argument is as follows:

Do you believe that it could be widely believed that the stock market will drop by 10% next week? If I believed that I'd sell like mad, and I expect that you would as well. Of course as we all sold and the price dropped, everyone else would ask around and when they started to believe the stock market will drop by 10% next week - why it would drop by 10% right now. This common sense is the heart of rational expectations models. So the correct conclusion is that our - and your - inability to predict the crisis confirms our theories.

However, this "model" assumes that everyone plays by the following rules:
1. Homogeneous expectations - everyone's belief is the same.
2. Common knowledge - everyone knows that everyone will act on this belief.

1. Heterogenous expectations around the mean.
2. Common knowledge - everyone knows that even if the expectation has some error, everyone will act on this belief.

So, what does it mean to be able to predict a crisis? It would be something like this: In the next 3 months the probability of a financial crisis has increased from 0.5 to 0.6 for instance. Predicting the crisis would not only mean this conditional probability (within a short time frame - less than a year but more than a month) it would also spell out the way the crisis would unfold.

It is the latter point that economics failed. While there were a lot of doomsayers who portended the crisis they focused on 1) global economic imbalances (mostly academic economists is my guess), 2) the housing bubble. Not a single economist was able to put a probability or a window in which this would occur and no one predicted the spectacular collapse of the financial industry.

If no economist was able to predict the chain of events (much less the likelihood of collapse), then can we really say that all crises are the same?

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