Predictability of Crises
By Arnold Kling
any macroeconomic theory that, in the midst of the housing bubble, would have predicted a financial crisis two years ahead with certainty would have triggered, by virtue of speculation, an immediate stock market crash and a spiral of de-leveraging and de-intermediation which would have depressed investment and consumption. In other words, the crisis would have happened immediately, not in two years, thus invalidating the theory. Thus, most crises are by nature unforecastable. Believing that they should be forecast is actually a positivist fallacy based on a false analogy between economics and the physical world.
our models don’t just fail to predict the timing of financial crises – they say that we cannot. 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.
Another argument they could make is that if policymakers saw a crisis coming, then they would take steps to stop it, so that it would not happen. Thus, any crisis that does occur has to be one that was not forecast.
But be careful here. I think these are good arguments for why a generally-believed forecast for a crisis can not be correct. But there is plenty of room for a given individual or method to forecast a crisis and not have enough people believe that forecast to take actions that would prevent it.
In the end, it will be interesting to compare the quality of the debate that takes place in the blogs with that in academic journals. In the journals, there may not be enough confrontation between opposing points of view. In the blogs, there is plenty of confrontation, but far too much vitriol for my taste. Paul Krugman, whose New York Times piece provoked much of the recent blog controversy, is not in the habit of bending over backwards to put his opponents in a good light. I think that other economists would do better not to adopt a such pejorative style, even if they agree with him on substance. Overall, a lay person would get the impression that macroeconomists are like cable TV partisans–all antagonism with no substance. A cynic might say that this is in fact the true state of macro, but even I don’t think it’s that bad.