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Why many economists missed the financial crisis

Mary Altaffer/The Associated Press/Mary Altaffer/The Associated Press

"This is not a golden moment for macroeconomics."

So said Joseph Stiglitz, the Columbia University professor and Nobel laureate, Friday at the Lindau Meeting on Economic Sciences.

This is Prof. Stiglitz staying true to form. He's been something of a gadfly to the economic establishment since he famously criticized the orthodoxy of the International Monetary Fund and the World Bank a decade ago after serving as the bank's chief economist. Prof. Stiglitz's latest current crusade against the establishment is over the failure to predict the financial crisis.

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He's not alone. William White, the Canadian economist who challenged former Federal Reserve chairman Alan Greenspan's policies well before doing so was popular, provided a powerful echo to Prof. Stiglitz's assertion during a discussion on the causes of the financial crisis on Saturday.

"Policy makers have a lot to answer for," Mr. White, who was the top economist at the Bank for International Settlements when he criticized Mr. Greenspan and is now an adviser at the Organization for Economic Co-operation and Development, said on the Lindau conference's final panel discussion, which was held at St. Gallen University in Switzerland.

It is Mr. White's contention that the policy makers, and especially central bankers, allowed themselves to think that their cleverness had allowed economies to move beyond classic boom-bust cycles. "Because it couldn't happen," Mr. White said, referring to policy makers' former belief in a future without financial crises, "no one tried to prevent it from happening."

There is a movement to rethink the application and study of macro-economics. This movement is based on a simple question: why did so many economists, with all their models and theories, fail to foresee one of the biggest economic calamites in history?

Here are a few of Prof. Stiglitz's answers to that question: the most commonly used economic models excluded the banking industry; policy makers such as Mr. Greenspan misunderstood the motivations of bankers, believing they were driven by keeping their firms out of trouble rather than the opportunity to enrich themselves; the U.S. economy isn't what it used to be because it is in a period of dramatic transition.

The third point has received less attention in the knee-jerk histories of the financial crisis than have the other two.

Prof. Stiglitz said Friday that the U.S. economy is going through an upheaval that is similar to the exodus of farm workers to the cities in the 1930's. Agricultural productivity reached the point where famers could produce massive yields with few workers. That was great for the farm owners and good for households because food became cheaper. But it was bad for those low-skilled agricultural workers who suddenly had no where to turn for work.

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The same kind of thing is happening now in manufacturing. Factories are now extremely productive, but no longer are big employers. The significance of this shift was masked in the years before the financial crisis, according to Prof. Stiglitz, by the credit bubble, which turned millions of erstwhile factory workers into home builders.

Prof. Stiglitz's criticism of the curent state of economics analysis is important. His celebrity attracts attention to a vital field of study, and his intellect and powers of argument force the profession to think hard about its mission. But there's certain amount of exaggeration to Prof. Stiglitz's claims.

Peter Diamond, the Massachusetts Institute of Technology professor who shared last year's Nobel Prize, is sympathetic to Prof. Stiglitz's world view. (Prof. Diamomd withdrew from consideration for a position at the Federal Reserve Board after some Republicans in the Senate refused to consider his nomination.)

But Prof. Diamond disagrees that central banks were as wedded to dysfunctional economic models as Prof. Stiglitz suggests, saying policy makers use several approaches to guide their thinking.

Prof. Stiglitz might also be exaggerating the breadth of the intellectual failure. There were plenty of economists who saw trouble coming, and there the profession has rallied aggressively to explain what went wrong, aiding efforts to overhaul global economic policy and financial regulation. Prof. Stiglitz's critique also comes with an underlying assumption that it's actually possible to create a framework that accurately foresees the outcome of the interactions of millions and millions of people. Avoiding market failures might not be possible.

"To say economics is broken is really to say, `Well, we had some people who were doing stuff that's right on point to what happened, and we had other people who were not, and the ones who were not happened to have more sway," said Prof. Diamond. "We don't have models putting it all together, and we maybe never will.

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Economists have become popular scapegoats for the global recession. Some prominent ones certainly must rethink what they though they knew. But the profession isn't lost. In fact, most of the more than 350 young economists who attended the Lindau conference feel good about their chosen profession.

"This is the best time," said Theodore Koutmeridis, a student at the University of Warwick in Britain. "People want to learn about economics" because of the crisis, Mr. Koutmeridis said in an interview this week. "This is a great opportunity to teach people from the beginning."

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About the Author
Senior fellow at the Centre for International Governance Innovation

Kevin Carmichael is a senior fellow at the Centre for International Governance Innovation, based in Mumbai.Previously, he was Report on Business's correspondent in Washington. He has covered finance and economics for a decade, mostly as a reporter with Bloomberg News in Ottawa and Washington. A native of New Brunswick's Upper St. More

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