The Great Recession: Making Fools of Economists

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“The state of the economy is good… The battles of yesteryear [are] over” – 2008, Olivier Blanchard: Chief Economist at The International Monetary Fund

“The central problem of depression-prevention has been solved”  – 2003, Robert Lucas: University of Chicago

The overconfidence of economists, as displayed by the quotes above, in the state of the macroeconomy prior to the Great Recession illustrates one of the central causes for the current economic downturn. The belief that economic problems had largely been solved led economists to idea that they could predict the market’s behavior; creating the perception that their risk was largely mitigated by this ability. So strong was their belief in the success of their field that economists claimed the markets were too inherently stable for any unforeseen downturn in the economy. We know better now however, and the economists who brazenly denied the possibility of a significant recession have been forced to swallow their words as the economy fights the greatest downturn since the Great Depression. Still, the economists were not the only individuals who held the belief that their ability to predict the movement of the “inherently stable” market allowed them to remove large amounts of risk.

When one looks back at the huge investments in sub-prime mortgages by large financial institutions, and searches for an explanation as to why this was believed to be a good idea, it becomes clear that the belief in the stable nature of the market allowed these investments to be considered safe. The large mortgage lenders felt that the economy was no longer unpredictable, and that they would have enough warning to change their strategies if there was the need. This belief led to financial institutions perceiving their investments as being diversified enough that, even in the event of a market failure, they would remain safe. They thought that, even if some of their investments failed, there was no way that enough of them would fail to put their companies in significant risk. Yet, like the economists who thought that the troubles of the past were securely in the past, they were wrong. However, unlike the economists, the financial institutions not only ended up looking like fools, but they also turned an industry specific downturn into a recession that completely changed the state of the economy. Personally, this brings some serious ethical questions to mind. In specific, I would like to know where is the accountability? Why are these financial institutions not being held responsible for their actions?

When Bernie Madoff lost his PRIVATE investors an estimated $65 billion, the federal government couldn’t move fast enough to prosecute him. Yet, when the practices of the large financial institutions costs the American PUBLIC an estimated $2.8 Trillion, the federal government gives them more money because they are “too big to fail.” Why the difference? The idea that these institutions are “too big to fail” is not sound; these institutions are affectively being placed in a position where they do not need to compete or innovate to remain viable because the government will support them. It seems that while the individuals responsible for the foolish lending practices should be held accountable, the government instead ignores the mistakes made by the large financial institutions. Opting to support them with the public’s tax dollars; making it look like  there is no incentive for these institutions to learn from their mistakes. Without such incentive learning cannot take place, and if our financial institutions cannot learn from the recession that has rocked the very foundations of our economic system then we are in very poor shape indeed.

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6 Responses

  1. I used the “How did Economists Get it So Wrong?” blog by Paul Krugman as a source. It can be found at: http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html

  2. Can you hot link some of the other pieces in your post? how about Madoff? Or other people or events?

    • I made links to both authors’ pages and a link to the Wikipedia about Madoff.

  3. […] The Great Recession: Making Fools of Economists […]

  4. […] The Great Recession: Making Fools of Economists […]

  5. I don’t think the bail out necessarily means those institutions don’t need to innovate. The reason they got the bail out was because they collapsed almost overnight. If they stop innovating they will slowly decline and be consumed by competitors, and the government would not raise a finger to help them.

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