Why did economists fail to predict global crisis?

In 2008 and 2009, global economic crisis unfolded. After the crisis, a question was raised as to whether the kind of economics taught to students in economics departments was responsible for the widespread failure to predict the timing and magnitude of the crisis. Critics asserted that excessive reliance on mathematical and econometric models was the main reason for the failure. The economic and financial meltdown resulted in a host of casualties. Economics is one such casualty. Peter Coy of Bloomberg Businessweek stated it very bluntly in 2009: "Economists mostly failed to predict the worst economic crisis since the 1930s. Now they can't agree how to solve it. What good are economists, anyway?"

This sounds easy from hindsight. It still begs the question: Why did the world's top-notch economics professors, Nobel laureates and mainstream economic analysts not foresee its arrival? Not a whisper came from their lips. This does not suit a discipline that aspires to be treated as a predictive science. Ben S. Bernake, chairman of the Board of Governors of the US Federal reserve system, confessed on September 24, 2010 that economists had failed to predict the nature, timing or severity of the crisis. Those few who issued early warnings generally identified only isolated weaknesses in the system. There were some namely Professor Raghuram Rajan from Chicago Uniersity, Nouriel Roubini of New York University and Stephen Roach of Morgan Stanley who were able to foresee the crisis. Their predictions tended to focus more on macroeconomic imbalances such as the current account deficit or the Federal government debt. They too were largely ignored by the central bankers.

Where is the problem? Formal models are incapable of capturing human emotions. People sometimes make decisions which are highly influenced by the sentiments and passions despite being well-informed of the core rational and economic facts. Nor are people always rational. What role did economics education play in this crisis? Some have argued that the study of economics makes people more selfish and greedy than otherwise would have been. This view does not survive harder scrutiny. Today's managers are not, on the whole, greedier or more narrowly self-interested than their predecessors because of what they learned in economics. Think of the landowners in ancient Rome, of the bankers and traders in medieval times, the behaviour of the East India Company in the 18th century, and of the industrial barons of the nineteenth century.

Naturally, those who think that economics education should fully stress the importance of socially responsible and honest conduct do have a point. Actually, this is the cornerstone of modern political philosophy and economics, as the works of Machiavelli and Smith make clear. The more fundamental lesson, however, is that one should not design institutions that require the highest moral qualities from all.

One should not hold it against economics that their teachings and models give a lot of attention to self-interest. Self-interest behaviour is inherent in human nature. Why that is so is beyond the realm of economics. Economics, as a positive science, cannot ignore this reality. But economic analysis should also focus on the common good and the connections between the individuals, business, and society. Are the models that we find in economics lacking in this regard? The answer is probably yes.

All famed economists appear to have realised that something is wrong with the financial theories they have been professing for decades. Hence, change within economics is inevitable, although such transformation is still unpredictable. The time is now right for new ideas to come in, much as they did in the 1930s and the 1970s.

The question is not whether economics will change, it is how this will change. Why should we care? The answer came from none other than John Maynard Keynes long time ago: "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else."

The writer is a research assistant in Accounting for Capital                Market Development project                under World Bank. [email protected]