Washington’s Blog 
Thursday, Nov 5th, 2009
The Wall Street Journal admits this week that economists blew it:
The pain of the financial crisis has economists striving to understand precisely why it happened and how to prevent a repeat…
The crisis exposed the inadequacy of economists’ traditional tool kit, forcing them to revisit questions many had long thought answered, such as how to tame disruptive boom-and-bust cycles…
“We could be looking at a paradigm shift,” says Frederic Mishkin, a former Federal Reserve governor now at Columbia University.
That shift could change the way central bankers do their job, possibly leading them to wade more deeply into markets. They could, for example, place greater emphasis on the amount of borrowing in the economy, rather than just the interest rates at which borrowing is done. In boom times, that could lead them to restrict how much money various players, ranging from hedge funds to home buyers, can borrow
But the Journal makes it sound like the policy-makers and economists who deployed faulty models were innocently ignorant of any larger truths:
The models “were not able to draw up the red flags,” says Tim Besley, a professor at the London School of Economics who served on the Bank of England’s policy-making committee until recently.
Barry Ritholtz has an excellent criticism of the article, pointing out :
There are many areas I would have liked to see the [journal’s] article explore: The lack of Scientific Method, the mostly awful performance of economists, its misunderstanding of the value of modeling, the bias inherent in Wall Street variant of economics, and lastly, the corruption of economics by politics...
Let’s start with the basics. Hard “science” — Physics, Biology, Chemistry, and all variants thereto — begins humbly. They try to describe the universe around us by creating theories, and then testing them. These theorems are always preliminary. Even when testing validates them, Science is always prepared — even eager — to replace them with newer theories that are proven to be even more valid.
The humility of science begins with an admission: We know nothing. We seek to learn through experiment and logic, and constantly evolve more and more accurate explanations. Scientific belief evolves gradually over time. Nothing is assumed, presumed, or hypothesized as true. Indeed, research is a presumption that current theories are inadequate or incomplete. The practice of science is a an ongoing search for better explanations, more proof, further verification — for Truth.
Science is the ultimate “show me” state.
Economics has a somewhat, shall we call it, less rigorous approach. Indeed, the arrogance of economics is that it is the polar opposite of Science. It begins with a few basic assumptions, many of which are obviously untrue; some are demonstrably false.
No, Mankind is not a rational, profit maximizing actor. No, markets are not perfectly, or even nearly, efficient. No, prices do not reflect the sum total of all that is known about a given market, sector or stock. Those of you who pretend otherwise are fools who deserve to have your 401ks cut in half. That is called just desserts. The problem is that your foolishness helped cut nearly everyone else’s 401ks in half. That is called criminal incompetence.
Where was I? Ahhh, our sad tale of the practitioners of the dismal arts.
Starting from a false premise that fails to understand the most basic behaviors of the Human animal, economics proceeds to build an edifice of cards on a foundation of sand. (How could that possibly go astray?) Like a moonshot off by a few inches at launch, by the time the we reach further into time and space, the trajectory is off by millions of miles . . .
Economics … creates an illusion of precision where none exists. The belief in their models led to all manner of mischief, from subprime to derivatives to risk management…
The Behaviorists have been fighting the mainstream for decades now, trying to correct the errors of the basic building blocks of the dismal science.
But I would go further in my criticism of the economic profession by arguing that the decisions to use faulty models was an economic and political choice, because it benefited the economists and those who hired them.
For example, the elites get wealthy during booms and they get wealthy during busts. Therefore, the boom-and-bust cycle benefits them enormously, as they can trade both ways.
Specifically, as Simon Johnson, William K. Black and others point out , the big boys make bucketloads of money during the booms using fraudulent schemes and knowing that many borrowers will default. Then, during the bust, they know the government will bail them out , and they will be able to buy up competitors for cheap and consolidate power. They may also bet against the same products they are selling during the boom  (more here ), knowing that they’ll make a killing when it busts.
But economists have pretended  there is no such thing as a bubble. Indeed, BIS slammed  the Fed and other central banks for blowing bubbles and then using “gimmicks and palliatives” afterwards.
It is not like economists weren’t warning about booms and busts. Nobel prize winner Hayek and others were, but were ignored because it was “inconvenient” to discuss this “impolite” issue.
Likewise, the entire Federal Reserve model is faulty , benefiting the banks themselves but not the public.
However, as Huffington Post notes :
The Federal Reserve, through its extensive network of consultants, visiting scholars, alumni and staff economists, so thoroughly dominates the field of economics that real criticism of the central bank has become a career liability for members of the profession, an investigation by the Huffington Post has found.
This dominance helps explain how, even after the Fed failed to foresee the greatest economic collapse since the Great Depression, the central bank has largely escaped criticism from academic economists. In the Fed’s thrall, the economists missed it, too.
“The Fed has a lock on the economics world,” says Joshua Rosner, a Wall Street analyst who correctly called the meltdown. “There is no room for other views, which I guess is why economists got it so wrong.”
The problems of a massive debt overhang were also thoroughly documented by Minsky, but mainstream economists pretended that debt doesn’t matter.
And – even now – mainstream economists are STILL willfully ignoring things like massive leverage , hoping that the economy can be pumped back up to super-leveraged house-of-cards levels.
As the Wall Street Journal article notes:
As they did in the two revolutions in economic thought of the past century, economists are rediscovering relevant work.
It is only “rediscovered” because it was out of favor, and it was only out of favor because it was seen as unnecessarily crimping profits by, for example, arguing for more moderation during boom times.
The powers-that-be do not like economists who say “Boys, if you don’t slow down, that bubble is going to get too big and pop right in your face”. They don’t want to hear that they can’t make endless money using crazy levels of leverage and 30-to-1 levels of fractional reserve banking, and credit derivatives. And of course, they don’t want to hear that the Federal Reserve is a big part of the problem.
Indeed, the Journal and the economists it quotes seem to be in no hurry whatsoever to change things:
The quest is bringing financial economists — long viewed by some as a curiosity mostly relevant to Wall Street — together with macroeconomists. Some believe a viable solution will emerge within a couple of years; others say it could take decades.
Note: I am not necessarily saying that mainstream economists were intentionally wrong, or that they lied because it led to promotions or pleased their Wall Street, Fed or academic bosses.Fed.
But it is harder to fight the current and swim upstream then to go with the flow, and with so many rewards for doing so, there is a strong unconscious bias towards believing the prevailing myths. Just like regulators who are too close to their wards often come to adopt their views, many economists suffered “intellectual capture” by being too closely allied with Wall Street and the
As Upton Sinclair said:
It is difficult to get a man to understand something, when his salary depends upon his not understanding it.