The failure of mainstream economics

Mainstream economists failed, with respect to the economic crisis, on three counts: they failed to predict the crisis, they didn’t even include the possibility of a crisis in their theories, and they didn’t know what to do once it happened.

Personally, I don’t put a lot of stock in prediction. But they do. And that’s because, as an excuse for the lack of realism in the assumptions of their theory, they claim all that matters is their models correctly predict the future trajectory of the economy.

And boy did they get it wrong. Simon Potter, who has reviewed the forecasts of the staff of the Federal Reserve Bank of New York, found enormous errors in the forecasts of real GDP growth and unemployment. On the former, the forecasts were off by 5.9 percentage points (a forecast of 2.6 percent growth versus actual growth in 2008 of -3.3 percent); on the latter, 4.4 percent points (equivalent to an unexpected increase of over 6 million in the number of unemployed workers). Oops!

Potter goes on to explain why he thinks they got it so wrong: they misunderstood the housing boom (because they found no convincing evidence of overvaluation), they had no analysis of the rapid growth of new forms of mortgage finance (because they relied on the assumption of efficient markets), and they gave insufficient weight to the feedback loops between the financial system and the so-called real economy (they simply didn’t connect the dots).

In other words, they failed. And the rest of us are now paying the costs.