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By Steve Kelman

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The Lectern: Academic economists and the economic crisis

I had an interesting discussion recently with a distinguished academic macroeconomist (somebody who studies issues involving the performance of the overall economy -- inflation, growth, unemployment -- as opposed to the behavior of individual consumers or firms) about the current economic crisis. After volunteering his opinion that the economic downturn will be sharp but relatively brief, he went on to tell me a story that turned into a fascinating self-confession on his behalf and that of his academic colleagues. He told me that two years ago, about when the housing market was reaching a peak, a group of the best academic macroeconomists in the Boston areas -- people from two-bit places such as Harvard and MIT -- met with Boston Federal Reserve Board officials about the situation in the housing market. There was a general consensus that the market was significantly overvalued and in the midst of a "bubble" situation. A number of those present ventured the opinion that housing market prices could easily decline by an average of 20 percent.

So those in attendance ended up right on that score. What was noteworthy, however, my colleague stated, was the inferences they drew from this about the impact of such a decline on the economy. They used standard macroeconomic models that looked at the impact on consumption of a wealth decline for homeowners (their houses would be worth less, this would make them feel poorer, and such a feeling would have some impact on consumption) and of unemployment in the construction industry from a housing downturn. Plugging the evidence on these into the models, the group was unanimous in its view that the effect of a 20 percent decline in home prices on economic growth would be minor.

What the group failed to understand, my colleague continued, was what actually happened -- the impact, via securitization/derivativization and prices of mortgage securities, of the housing decline on the balance sheets and solvency of financial institutions, with the further impact on credit contraction and hence growth/employment. These impacts via the financial system were not in their theories or models. Academic macroeconomists were unaware of the new financial instruments of the last decade. There are academics who were aware of these and studied them, but these are academics who study finance, and they know little about macroeconomics and ripple effects of credit contraction on economic growth. As academic specialization and subspecialization has grown, different academic subdisciplines, even with one larger overall discipline such as economics, have become very much like the worst stovepipes in government and private organizations. For this economic crisis, like for 9/11, there was a failure within academia to "connect the dots."

To put it mildly, I am not one of those who makes fun of the research or the insights of scholars, but I felt my colleague's comment about the failure here of the smartest academic economists was revealing. Of course, a lot of smart practical people -- including the leaders of Wall Street -- did no better. So this is no occasion for professor-bashing.

This will be my only post for this week, coming a bit early. I will take a Thanksgiving break on Thursday. Best Thanksgiving wishes to all my U.S. readers. Do my international readers know anything about Thanksgiving or have any U.S. Thanksgiving experiences to share?

Posted by Steve Kelman on Nov 24, 2008 at 12:10 PM


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