Why can't economists predict financial crises?
They're making progress, but they're not there yet.
My last post was about how advances in financial economics — and the leadership of Ben Bernanke, who was himself responsible for some of those advances — averted a second Great Depression in 2008-10. Some commenters pushed back, however, arguing that Bernanke and economists as a whole should have seen the crisis coming ahead of time and averted it, rather than just reducing the damage when it hit.
There’s no question that the Fed failed to anticipate the crisis of 2008. Documents from Fed meetings in 2007 show that officials — including Bernanke and his successor Janet Yellen — anticipated a soft landing. Yellen has admitted that although they saw warning signs — a housing bubble, a debt buildup, etc. — economic policymakers simply failed to realize what a huge crises these would cause. In a 2015 interview, Bernanke said:
[W]e were aware of the fact that house prices were very high. And we thought it quite possible that they would correct at some point. By 2006, 2007, we also were aware of the problems in the subprime lending market. What we did not anticipate and no one anticipated was the vulnerability of the financial system overall to a run, a panic. You know, in the 19th century, early 20th century, we had bank runs all the time. People would run to the bank, pull their cash out and the bank would have to close. That was this, in the 1930s story. So now we have [FDIC] deposit insurance. We didn’t see that coming.
In other words, both shadow banks and the interbank lending market were subject to bank runs, and not protected by the FDIC, and economists failed to realize this.
So it does make sense to ask: Why? And did others successfully predict the crisis? And is there a way to consistently predict crises like these? This is not an easy question to answer. There are people who claim that it’s logically impossible for economists or policymakers to predict crises in advance, but — as I’ll explain in a bit — this is wrong. In fact, lots of economists do work on ways to detect when the economy is at risk of a financial crisis; there’s no reason to think it’s an insane, futile endeavor.
But at the same time, we — meaning humanity — just haven’t made very many breakthroughs in this area yet. Many self-proclaimed “heterodox” thinkers declare that it’s easy to see crises coming, but they are also wrong, and their predictions of repeat crises since 2008 have not held up. This is simply a very, very difficult problem. Economists are making some real progress, but they’re not there yet.
What does it mean to predict a financial crisis?
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