Bubbles and Bailouts: Why Some Economists Failed

Bubbles and Bailouts: Why Some Economists Failed

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Economists have been criticized for their performance during the financial crisis, rightly at times, but not all of the criticism has been fair.

It's true that macroeconomists, as a group, did not see the signs of the disaster that was about to hit the economy. There were a few lonely voices who warned that a dangerous bubble was building in the housing market, but they were mostly ignored. And even after the economy’s troubles became evident, it took macroeconomists longer than it should have to correctly diagnose the problem as a balance sheet recession.

But once macroeconomists understood the nature of the difficulties we were experiencing, policies to effectively battle this type of recession were proposed. Unfortunately, the proposals were mostly ignored.

The banks got plenty of attention from both monetary and fiscal policymakers, but efforts to replace the lost demand hurting businesses, to help households repair their balance sheets, to create jobs for the unemployed, and to help state and local governments avoid cutbacks forced by balanced budget requirements fell far short of what was needed.

But I don't think this failure can be blamed on economists. There was no shortage of effort from many of us to get policies like these enacted. The question is why nobody listened.

For fiscal policy the answer is clear and simple. Congress is broken, and it no longer has the ability to work for the common good. Perhaps eliminating the filibuster, removing money from politics, reversing Citizens United, and so on would help – that remains to be seen – but as it stands, Congress is clearly dysfunctional.

And that dysfunction coupled with the influence of big money interests caused Congress to listen to the wrong voices. Instead of paying attention to economists who had been right about the recession all along, Congress listened to the voices that had mostly gotten things wrong. In large part, the people who favored deregulation of the financial sector, assured us there was no housing bubble, and told us problems could be easily contained even if there was a bubble are the very same people who brought us the push for austerity, the fear of inflation, the fear of bond vigilantes, and so on, none of which was helpful.

These economists told Republicans and centrist Democrats in Congress what they wanted to hear, things that allowed them to avoid difficult policy choices or pursue ideological agendas, and they were given prominence in policy discussions. The economists who got it mostly right disagreed with these policies in no uncertain terms, but Congress didn't want to hear what they had to say and fiscal policy suffered because of it.

But how can we explain the problems with monetary policy? The Fed is supposed to be free of the political constraints that make it so hard for Congress to put the proper policies in place, and the members of the FOMC are mostly economists so the problems can’t be blamed on politicians or others outside the economics profession. Yet the Fed has been much too timid and apprehensive in its response to the recession, presumably because it is worried about how an outbreak of inflation might affect its credibility and independence.

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For example, the Fed is presently missing both its inflation and unemployment targets, and economists outside the Fed from both the right and the left are largely united on the need for more aggressive policy. But even though there is little evidence to support the Fed’s worries about inflation, the Fed has been sitting on its hands in the “wait and see” mode that has left it behind the curve again and again over the last several years.

There are hopes that will change at the next FOMC meeting, but the Fed is unlikely to be as aggressive as outside critics would like it to be. And it’s particularly disturbing to read in the minutes from the last FOMC meeting that “Several participants commented that it would be desirable to explore the possibility of developing new tools to promote … a stronger economic recovery.” They are just now thinking about exploring alternative policies? We’re in a crisis situation, and this hasn’t been fully explored already?

So while I can offer a partial defense of economists – Congress has ignored the economists it ought to be listening to – a full defense is impossible. The continued push from some economists for austerity, interest rate increases, and other policies that satisfy political and ideological goals but work against the recovery, and the failure of economists in charge of monetary policy to adopt policies consistent with the Fed’s mandate undermine any attempt to fully defend the economics profession.

We can fix our economic models, at least I hope we can, and maybe we can fix our political institutions, we shall see, but how do we fix the economists standing in the way of better policy?