Crisis? What crisis?

David Miles, former Bank of England MPC member and now professor of economics at Imperial College, this week issued a clear rebuttal (here) of Andy Haldane’s charge that economics is in “crisis” (here). Miles makes the point very bluntly: “If existing economic theory told us that such events should be predictable, then maybe there is a crisis. But it is obvious that economics says no such thing … In fact, to the extent that economics says anything about the timing of such events it is that they are virtually impossible to predict; impossible to predict, but most definitely not impossible events.” 

He then goes on to point out that basic economics, in which organisations act in their own best interests, explained perfectly well why the financial crisis happened. In a world in which banks knew that they would face only a limited liability for the losses they created, and where the tax system favoured debt over equity, they had every incentive to increase their leverage. He also reminded us that there is a whole literature on market failure and that economists have won the highest academic honours for “exploring the ways in which free market outcomes can sometimes generate poor results.”

Indeed, when you think about it, the record of economists in predicting economic shocks is no worse than that of seismologists in predicting earthquakes. There are various warning indicators which signal that an earthquake may be imminent but scientists cannot pinpoint accurately when they will happen, and certainly not months or years in advance. Or, as Miles put it, “any criticism of “economics” that rests on its failure to predict the crisis is no more plausible than the idea that statistical theory needs to be rewritten because mathematicians have a poor record at predicting winning lottery ticket numbers.”

As I have noted on numerous previous occasions, economics is not a predictive discipline so we are forced to do the best we can in order to meet the demand for predictions of future economic activity. And unfortunately, despite the best efforts of former UK Chancellor Gordon Brown to abolish boom and bust, we are faced with the problem of simultaneously trying to predict the amplitude and frequency of an economic cycle which is not regular. It can shift abruptly, which leads to structural breaks in our model-based forecasts. If there is a “crisis” in economics it is that too much mainstream policy analysis focuses on the central case outcome, which becomes a binary choice as to whether the forecast in question was attained. This raises a question of whether a forecast for 2% GDP growth in any given year is “wrong” if it turns out to be 2.2%. It is a pointless exercise to strive for that sort of precision, which raises the question of how far away we are allowed to be from the central case before our prediction is deemed “wrong”. 

In fairness the likes of the BoE have long maintained that it is the distribution of risks around the central case which is important (and many others are now catching on). By defining the probability distribution around the central case we then have some idea of the plausible range of outcomes. But we have to accept that economics cannot predict the point at which the steady state switches from one condition to another, in much the same way that quantum physicists cannot determine with any precision the degree to which certain pairs of physical properties of a particle can be known. In other words, we cannot forecast structural shifts.

But one of the things that economics can do is to figure out how behaviour will change once the structural shift has occurred. Forecasters may not have incorporated the crash of 2008 into their central case (I will expound on some of the reasons why on another occasion) but expectations adjusted quite quickly thereafter. It was treated as a structural break with profound consequences for near-term growth, and consensus GDP growth numbers were revised down sharply thereafter, as indeed were expectations for central bank policy rates. Seismologists may not always be able to predict when the earthquake will strike but they know what the consequences will be when they do