What Caused the Financial Crisis? Don’t Ask an Economist
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The Fiscal Times
August 30, 2011

What caused the financial crisis that is still reverberating through the global economy? Ask a bunch of economists, and you’ll get a Babel of answers.

When the crisis was finally discussed at last week’s 4th Nobel Laureate Meeting in Lindau, Germany— a  meeting that brings Nobel laureates in economics together with several hundred young economists from all over the world -- the reasons cited for the financial meltdown were all over the map.
It was the banks, the Fed, too much regulation, too little regulation, Fannie and Freddie, moral hazard from too-big-to-fail banks, bad and intentionally misleading accounting, irrational exuberance, faulty models, and the ratings agencies. In addition, factors I view as important contributors to the crisis, such as the conditions that allowed troublesome runs on the shadow banking system after regulators let Lehman fail, were hardly mentioned at all.

Macroeconomic models have not fared well in recent years — the models didn’t predict the financial crisis and gave little guidance to policymakers, and I was anxious to hear the laureates discuss what macroeconomists need to do to fix them. So I found the continuing disagreement distressing. If the very best economists in the profession cannot come to anything close to agreement about why the crisis happened almost four years after the recession began, how can we possibly address the problems?

I suppose we could try to fix all the problems that have been identified – some subset of them is likely to be the real cause. But that unnecessarily constrains a whole range of activities in the hope that we limit the particular behaviors at the root of the crisis. That’s an inefficient way to fix the problem. And, in any case, how do you proceed when some of the causes cited by economists are at odds with each other? If one view says it was too much regulation and the other says it was too little, it’s not possible to do both at once.

How can some of the best economists in the profession come to such different conclusions? A big part of the problem is that macroeconomists have not settled on a single model of the economy, and the various models often deliver very different, contradictory advice on how to solve economic problems. The basic problem is that economics is not an experimental science.

We use historical data rather than experimental data, and it’s possible to construct more than one model that explains the historical data equally well. Time and more data may allow us to settle on a particular model someday – as new data arrives it may favor one model over the other – but as long as this problem is present, macroeconomists will continue to hold opposing views and give conflicting advice.

This problem is not just of concern to macroeconomists; it has contributed to the dysfunction we are seeing in Washington as well. When Republicans need to find support for policies such as deregulation, they can find prominent economists – Nobel laureates perhaps – to back them up. Similarly, when Democrats need support for proposals to increase regulation, they can also count prominent economists in their camp. If economists were largely unified, it would be harder for differences in Congress to persist, but unfortunately such unanimity is not generally present.

This divide in the profession also increases the possibility that the public will be sold false or misleading ideas intended to promote an ideological or political agenda.  If the experts disagree, how is the public supposed to know what to believe? They often don’t have the expertise to analyze policy initiatives on their own, so they rely on experts to help them. But when the experts disagree at such a fundamental level, the public can no longer trust what they hear and that leaves them vulnerable to people peddling all sorts of crazy ideas.

When the recession began, I had high hopes that it would help us to sort between competing macroeconomic models. As noted above, it's difficult to choose one model over another because the models do equally well at explaining the past. But this recession is so unlike any event for which there is existing data that it pushes the models into new territory that tests their explanatory power (macroeconomic data does not exist prior to 1947 in most cases, so it does not contain the Great Depression). But, disappointingly, the crisis has not propelled us toward a particular model as would be expected in a data-driven, scientific discipline. Instead, the two sides have dug in their heels and the differences – many of which have been aired in public – have become larger and more contentious than ever.

University of Oregon macroeconomist Mark Thoma writes primarily about monetary policy its effect on the economy. He has also worked on political business cycle models. Thoma blogs daily at Economist’s View.