Myopic Hindsight

By Ocean in Articles, Bubbles, Featured, Our Theory

The online business news outlet, Knowledge@Wharton, is one of the better resources for business and finance news around, so when they come out with an article entitled Why Economists Failed to Predict the Financial Crisis, it shows that this point of view is not a sense of hubris on Wharton’s part, but rather a sign of the times.

Every other article on finance and economics these days highlights what went wrong, and how the writing was on the wall, and yet it was unforeseen by politicians, bankers, financiers, the public, etc. Most examples bring up LTCM and derivatives, every example mentions the housing crisis and bankers and goes on to blame free markets. Wharton’s article is no different. What makes it different is that it aims to objectively look at our recent past to see what went wrong, yet in doing so it is rewriting history.

The gist of the article is that many people did not foresee the housing bubble and all the consequent woes. This can be justified for journalists, real estate agents, politicians and the like, but “what about economists? Of all the experts, weren’t they the best equipped to see around the corners and warn of impending disaster?“. It then goes on to explain how economists were blinded by “a free-market bias in the profession, coupled with outmoded and simplistic analytical tools“.

Due to this, they “badly underestimated the risks of new types of derivatives“, which caused them to “ignore evidence of irrational behavior that is well documented in other disciplines like psychology and sociology“, and therefore “few people knew that major financial institutions had become so heavily leveraged in real estate-related assets“.

(Please forgive all the embedded quotes, but they do fit in nicely)

This could all very well explain what happened in the market, if it were true. Unfortunately it’s hogwash.

A case in point is the June 18th, 2005, cover story of The Economist:

If you have read the Economist, you probably know they are major proponents of free trade and free markets. They start off the cover story with:

PERHAPS the best evidence that America’s house prices have reached dangerous levels is the fact that house-buying mania has been plastered on the front of virtually every American newspaper and magazine over the past month. Such bubble-talk hardly comes as a surprise to our readers. We have been warning for some time that the price of housing was rising at an alarming rate all around the globe, including in America. Now that others have noticed as well, the day of reckoning is closer at hand. It is not going to be pretty. How the current housing boom ends could decide the course of the entire world economy over the next few years.

While obviously some economists did not foresee any sort of housing bubble, many had (the Wharton economists are unclear as to in which category they put themselves). The convenience of writing today about how it was a completely unforeseen phenomenon is that it: A) explains what went wrong in a simple fashion. “These economists weren’t up to par and had outdated models” is better than “Many of them had it right but we were too busy buying houses to pay attention.”, and B) it serves as a perfect launching pad for Behavioral economics, which seems to have entered in vogue with a vengeance.

As we have explained in the past, we at Dumbagent have no problems with behavioral economics, although we feel attacks from the behavioral camp towards efficient markets will increase. We believe behavioral economics will become an entrenched part of economics, although it will be given too much credit in the coming months, as the pendulum swings its way.

And at the risk of adding our own myopia to this hindsight, we reiterate that the housing bubble was caused by over-speculation. While this may seem simplistic, it holds. It has been mentioned that bubbles will only occur with stocks, artwork or antiques. This crisis, of course, proved that wrong, although the reasons for it still apply. When people buy something not for its inherent value, but for the sole purpose of reselling it at a later date, a bubble can occur. Bubbles will never occur in apples while we just buy them to eat them. If we start buying them to hold and then resell them at a profit, we can expect a bubble. If you really do want a takeaway from this downturn, you could do worse than learn this.