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Economists Explain Why Hints of the Economic Crisis Eluded Them

January 9, 2009 at 6:25 PM EDT
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Some of the nation's brightest economists failed to predict the foreclosure crisis and economic recession that followed. Paul Solman asks them why no one connected the dots in time to warn the public.

PAUL SOLMAN: Cassandra Bob Shiller, who’s warned for a decade of “irrational exuberance” and an eventual bust of the housing and stock markets.

So, prices were going up, up, up, and it seemed like it would never end, right?

ROBERT SHILLER, Yale University: It must have seemed that way. I don’t know how people could believe that. They just can’t go up, up, up. We’ll end up in the stratosphere.

PAUL SOLMAN: This was a grand tour of San Francisco with Bob Shiller and Nobel laureate George Akerlof, taking a break from some 10,000 colleagues in town for the yearly economics convention to which we’d come to ask one question…

Why didn’t you, the economics profession, warn us? Why didn’t the Fed tell us?

ECONOMIST: Why didn’t we warn you?


ECONOMIST: We collectively or me personally?

PAUL SOLMAN: Well, either one.

Many said they had sounded the alarm, but that in good times no one listens, especially if there’s a good story on the other side.

ROBERT SHILLER: The idea is, because of the population growth, which will go on forever, that was the assumption, the economy is growing, because China and India are showing the way that capitalism is exploding, and that seems like, well, maybe that is a reason that prices are just going to go up, up and up. And they forgot about the fact that they might go down, and down, and down.

PAUL SOLMAN: The convention itself was packed with top-flight economists, holding forth to peers and newly minted PhDs. But many didn’t warn us. So why? Alan Blinder was vice chairman of the Fed in the 1990s.

ALAN BLINDER, Princeton University: I think the fair answer is nobody thought that this might happen. Things can go wrong. But the number of things that have gone wrong and the ferocity with which they have gone wrong, I think, was beyond the imagination of almost everyone.

PAUL SOLMAN: Or as Stanford’s Caroline Hoxby put it…

CAROLINE HOXBY, Stanford University: It was easy to say this individual housing, mortgage investment is risky, but it was very difficult for any — even a very good economist to say, “I understand how all of these different investments, when they all start collapsing together, even just a little bit, are going to aggregate up and roll onto one other.”

It’s like understanding how all the dominoes are going to hit one another. That’s a much tougher problem.

PAUL SOLMAN: And how can you ever know that, asked finance Professor Zvi Bodie?

ZVI BODIE, Boston University: Disasters can happen at any time. In fact, what makes them disasters is we’re not expecting them. If we were expecting them, they wouldn’t turn into disasters.

PAUL SOLMAN: But, in fact, there was plenty of data to suggest the worst and plenty of economists who saw it coming, from Dean Baker and Jamie Galbraith on the left to Martin Feldstein and Ken Rogoff on the right.

So why were so many others blindsided? Because we were all so lied to, says MIT’s Frank Levy.

FRANK LEVY, Massachusetts Institute of Technology: I think part of the reason that many people didn’t know is that the people who were issuing all these derivatives had big incentives to keep what they were doing secret.

Same thing with the banks. If the banks put on their books all the risky loans they were carrying, all the risky loans they were making, the Federal Reserve would step in and say, “Well, you have to increase your capital requirements,” and that would mean the banks could make fewer loans.

They didn’t want that. They wanted to make all the loans they could to generate all the fees they could. So everybody in this game had big incentives to keep hidden an awful lot of the activity they were doing.

PAUL SOLMAN: But the convention’s most liberal economists had another explanation for the lack of warning: the ideology of the era.

Nobel laureate Joe Stiglitz.

JOSEPH STIGLITZ, Columbia University: People wanted to believe that markets were self-regulating. And if that was the case, you couldn’t have a bubble, because if there was a bubble, you needed to have somebody do something about it.

And so this ideology which rose, the notion that there would be that government always got in the way, that regulation was bad, was a central piece in the ability of both the profession and politics to look the other way.

PAUL SOLMAN: And those who long ago begged to differ were marginalized, said Duke’s William Darity.

WILLIAM DARITY, Duke University: There is not much of a tendency to hire economists who think outside of the box. And so, as a consequence, I think there was sort of an ideological blinder that was on — on peoples’ eyes.

PAUL SOLMAN: Instead, those inside the box prevailed, thinking markets regulate themselves. Nobel laureate Ken Arrow is a living legend at this gathering.

So the question we’re asking everyone is, why didn’t you warn us?

KEN ARROW, Stanford University: Exactly. Well, I feel a little responsible, in a way. I should have. We just assumed, if we knew it, so did the people, the smart people — that would have no reason to distrust their intelligence — in the investment banks, so we took it for granted these people protect themselves. We were wrong, obviously.

PAUL SOLMAN: But it’s time to go back to our tour and onto the next stop, North Beach, among other things, San Francisco’s puppy paradise.

ROBERT SHILLER: People are driven by their animal spirits.

PAUL SOLMAN: Shiller and Akerlof have written a new book about animal spirits, the words of England’s Great Depression economist John Maynard Keynes, which we love using in our pieces for the visuals.

To these economists, animal spirits are the key to both the crash and our failure to anticipate it. They’re the emotions that actually animate an economy, like trust and confidence. And they tend to ebb and flow, for better and worse.

ROBERT SHILLER: The basic problem I would say is that we became overconfident, and then we discovered that it was built on faulty premises, and now our confidence is crashing.

GEORGE AKERLOF, University of California, Berkeley: I think the major thing was that people simply were too trusting. They trusted that they could buy mortgages and things like that which simply were not going to pay off. And they should have been much more careful.

PAUL SOLMAN: But, of course, this is easier said than done when riding a wave of prosperity. In fact, the act of making money can induce an actual physical high, says economist Andrew Lo.

ANDREW LO, Massachusetts Institute of Technology: It turns out that neuroscientists have shown that financial gain triggers the exact same reward circuitry in the brain that cocaine does.

So when you’re making money, you’re actually engaged in a kind of activity that generates a drug-induced stupor in much the same way that having a few drinks or being on cocaine would actually make you relax and be a lot less concerned about risk.

Now, if you take it to the extreme, if you take hallucinogenics, where not only do you not worry about the risks, but you don’t even see the risks, that can get to a situation where you walk off a 30-story building because you think you can fly.

PAUL SOLMAN: OK, so our animal brains, even the biggest ones, perhaps, are subject to inebriation. So then shouldn’t government play the role of sobersides?

Unfortunately, said Republican Martin Feldstein, who warned of a severe crisis two years ago…

MARTIN FELDSTEIN, Harvard University: There’s always a tendency in Washington to be optimistic, to think that things are going to improve.

PAUL SOLMAN: In the end, then, every person in the game had an interest in keeping it going. Berkeley’s Laura Tyson.

LAURA TYSON, University of California, Berkeley: A central lesson is that this is a kind of Greek tragedy, where the explanation of the tragedy is human failings deep within what it means to be human.

And what it means to be human is sometimes to go to excess, to basically not pay enough attention to risk. Humans make those kinds of mistakes consistently, and it’s led to some of the great crises in history. It’s also, frankly, led to some of the great accomplishments in history, but it’s all about us as people.

PAUL SOLMAN: The tragedy of underestimating risk takes us to the last stop on the cable car line and for this piece, Market Street, scene of another panic a century ago.

ROBERT SHILLER: The earthquake of 1906 was preceded by many California earthquakes. And there were architects and urban designers who were saying you needed to prepare better for the next one.

The reason it was so bad was because they didn’t prepare. The problem was nobody wanted to face and come up with the cost and the expenditure of preventive measures which would have limited the damage of that earthquake.

PAUL SOLMAN: And now for years we’ve been hearing about the imminence of, in California, “the big one,” yet you live here. Why?

GEORGE AKERLOF: It’s a great place to live. Of course, I live here. I don’t think about it.

PAUL SOLMAN: So you, in your everyday life, are in a version of the willful denial that we’ve all been in, in this country with regard to the economy, for years?

GEORGE AKERLOF: That’s exactly right.

PAUL SOLMAN: George Akerlof, that is, has left his heart in San Francisco. And the heart has its reasons and the mind its receptors for which reason seems to be no match.