Monday, September 21, 2009

Predictability of the Crisis

Alex Tabarrok weighs in on the argument that no macro model could predict the crisis.
...the word timing is misleading. Let's accept that a crisis cannot be predicted to the day or even to the year. Nevertheless, it is perfectly reasonably and fully consistent with rational expectations to predict an increased probability of a crisis.

If you play Russian Roulette with 1 bullet and 100 chambers in your pistol, I can't predict when the crisis will occur. If you play with 10 bullets, I still can't predict when the crisis will occur but I can say with certainty that the risk has increased by a factor of ten. Analogously, nothing in modern economics makes it theoretically impossible to forecast that greater leverage and higher than normal price to rental rates, to name just two possibilities, increase the probability of crisis. Nor does modern theory make it theoretically impossible to forecast that conditions are such that if a crisis does occur it will be a big one.

All of this is true even in the context of stock markets. Efficient markets theory implies that any two stocks will have similar risk-adjusted returns it does not imply that the risk of bankruptcy is the same for any two firms. It is perfectly reasonable to say that Google revenues are going to have to increase at a historically unprecedented rate or the stock will plummet. It is even consistent with efficient markets theory to predict that the probability of Google stock falling is much greater than the probability of it rising (but if it rises it will rise very far, very fast).

Thus the "we could not have predicted the crisis even in theory" argument is a weak defense--even with rational-actor, rational-expectations models there are plenty of senses in which economists could have better predicted the crisis and, although this is yet to be seen, perhaps they could and will do even better with other sorts of models.

It seems to me, however, that once you define the problem as one of predicting increased risk of a crisis then the charge against macroeconomics is lessened. Many economists argued that the risk of a crisis had increased after 2006.

The notion that economists should be able to isolate periods of increased risk is a good one. The IMF has tried to do that with early warning indicators. The BIS was warning of increased risks from at least 2006.

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