PhD Economist Derp: Didn’t See Crisis Coming, But Listen to Us on How to Fix

Economic Fundamentals, Information Matrix, PhD Economist Derp

31 Jan 2018

In late 2008, the Queen of England asked why the Economics profession didn’t see the financial crisis coming. Since then PhD Economist derp has been in overdrive trying to answer her question in a way non-Economists will find acceptable.

The latest defense comes from Simon Wren-Lewis.

We can distinguish between a conditional and an unconditional forecast. An unconditional forecast says what output will be at some date. A conditional forecast says what will happen to output if interest rates, and only interest rates, change. An unconditional forecast is clearly much more difficult, because you need to get a whole host of things right. A conditional forecast is easier to get right.

Paul Krugman is rightly fond of saying that Keynesian economists got a number of things right following the recession: additional debt did not lead to higher interest rates, Quantitative Easing did not lead to hyperinflation, and austerity did reduce output. These are all conditional forecasts. If X changes, how will Y change? An unconditional forecast says what Y will be, which depends on forecasts of all the X variables that can influence Y.

We can immediately see why the failure of unconditional forecasts tells us very little about how good a model is at conditional forecasting. A macroeconomic model may be reasonably good at saying how a change in interest rates will influence output, but it can still be pretty poor at predicting what output growth will be next year because it is bad at predicting oil prices, technological progress or whatever…

This also helps tell us why policymakers like to use macroeconomic models to do unconditional forecasting, even if they are no better than intelligent guesswork… [emphasis added]

Shorter: Unless a PhD Economist gets lucky, the models Economists use are incapable of forecasting future economic conditions. So don’t expect Economists to accurately forecast a future recession or financial crisis. That is too tough to do.

Not sure this is a great defense of Economists’ models, but it is the one he chose.

If the models are not good at predicting future economic events and since the start of the Great Financial Crisis this has been shown to be true, why should anyone trust they offer any insights into the economy and the policies to pursue to recover from a recession let alone a financial crisis?

Anticipating this question, Wren-Lewis embraces Paul Krugman’s strategy of painting a bullseye around a couple of conditional forecasts after seeing where the conditional forecast (arrow) lands.

Is this legitimate or is it pure PhD Economist derp?

Let’s look at a conditional forecast Wren-Lewis left off his list. Consider the conditional forecast offered to justify the policy responses to the Great Financial Crisis. The conditional forecast was without these policy responses we would have a second Great Depression.

Were there any Economists using their models saying this conditional forecast was wrong because it was fundamentally flawed? No! This point is worth repeating. The Economists’ models supported the conditional forecast if the policymakers did nothing we would experience a second Great Depression.

Was there any reason to think this conditional forecast was wrong when it was first uttered? Yes! In fact, I said so. I even pointed out why. This wasn’t brilliance on my part. It was recognition the people who lived through the Great Depression and redesigned the global financial system would have taken precautions to prevent another Depression from occurring.

So who was right about this counter-factual: the Economists with their models or me?

As Nobel prize winning Economist Paul Krugman observed,

So the world financial system and the world economy failed to implode. Why?

We shouldn’t give policy-makers all of the credit here. Much of what went right, or at least failed to go wrong, reflected institutional changes since the 1930s. Shadow banking and wholesale funding markets were deeply stressed, but deposit insurance still protected a good part of the banking system from runs. There never was much discretionary fiscal stimulus, but the automatic stabilizers associated with large welfare states kicked in, well, automatically: spending was sustained by government transfers, while disposable income was buffered by falling tax receipts. [emphasis added]

As Professor Krugman points out, the institutional changes put in place by the people who lived through the Great Depression, deposit insurance and the automatic stabilizers, did exactly what they were suppose to do which was to prevent a second Great Depression.

Hmmmm…..

What we are left with is pure PhD Economist Derp.