Were economists wrong because of economic incentives ?

Matthew Yglesias writes

Ragu Rajan … his explanation of why economists didn’t predict the crisis:

I would argue that three factors largely explain our collective failure: specialization, the difficulty of forecasting, and the disengagement of much of the profession from the real world.

Rajan glosses a leading alternative hypothesis thusly:

Finally, an answer that is gaining ground is that the system bribed economists to stay silent.

Obviously bribe-based theories of human behavior are crude and rarely capture reality. But how about translating this into economics? How about incentives? Rajan says it’s not individual corruption that led to a lack of insight, it’s structure features of the way the profession is organized. That makes a lot of sense to me. But what explains that structural organization? Is it really unrelated to the financial basis of the economics profession? Or are economists supposed to be immune from the factors that influence human behavior in other instances?

I comment

I will try to guess if the system is bribed to stay silent. I am technically an economist, but not part of the system (that is not an elite economist). To start with my conclusion, I don’t think that the blindness of elite economists can be explained as a rational or semi rational response to incentives. I think that Rajan happens to be right about what went wrong this time.

I explain why I believe this after the jump.

Very few economists saw it coming (and they might have just guessed right or strategically made an extreme prediction which is like buying a lottery ticket). I’d say two things blinded economists, the EMH and DSGE (acronyms explained below). Neither was paid for by firms or rich individuals.

First the Efficient Markets Hypothesis (EMH) which holds that all assets always sell for the same price they would have if everyone had rational expectations. Basically it says there are no bubbles even in housing *and* that if there is a housing bubble then mortgage bonds and CDOs of mortgage bonds and CDSs on CDOs of morgage bonds are all correctly prices. Clearly no advocate of the EMH could see it coming.

For some reason, the EMH remains the default position of many academic economists. Worse, one exception at a time is allowed, so people see if one asset is correctly priced assuming all other assets are correctly priced. There is no way this approach could lead to a prediction that the recent crisis was even possible.

Also, iit would be a total catastrophic disaster for the financial services industry if the general investing public believed the EMH. If anyone took it seriously when investing (as opposed to when writing academic articles) then the financial services industry couldn’t make much money dealing with that person. If one believes in the EMH and doesn’t have private information (not a strategy or algorithm or theory but knowledge of relevant facts which almost no one knows) then one should buy and hold the market portfolio. This means low trading volume and low fees. This means you buy equal amounts of all tranches of CDOs (except you already have the pool of underlying assets so you don’t bother). This means you don’t pay someone to manage your money unless that person has private information.

The Financial services Industry makes its huge profits at the expense of suckers who think they can beat the market. Partly by charging them fees and partly by betting against them (since the EMH is false financial professionals can make money with simple rules). Belief in the EMH would kill the goose that lays the golden eggs.

Yet academic economists have been promoting the EMH for decades. This just couldn’t be the effect of being bribed *or* of some indirect influence of group interests on sincere beliefs or anything. The bought off hypothesis just doesn’t fit the facts.

The use of DSGE (dynamic stochastic general equilibrium) models also guarantees failure to see it coming. It also has nothing to do with consulting. There is a sharp devision between academic macroeconomics and macroeconomic forecasting. It is done by different people. Some people are paid for forecasts. Clearly they have all sorts of interesting incentives which have been analysed at gruesome length by academic economists who, contra Yglesias, pay attention to incentives of forecasters. They don’t use DSGE models. They missed it too, but they aren’t the people Rajan was writing about. As far as I know, there is no rich or concentrated group which promotes DSGE models. People who pay macroeconomists pay completely different macroeconomists who do completely different things. They don’t know or care what DSGE stands for.

I may be overstating my claim. It may be that DSGE models tweaked to give the same forecasts as atheoretic models are used. But no one has an interest in paying the middle man (the tweaked theory).

I’d say the way in which money has influence economics is by promoting in general a right wing slant (compared to view best supported by the evidence). Many prominent economists are very right wing. If asked, they advise people to vote for Republicans. Now I note that US economists are on average a bit to the left of the US center (the general academic thing beats the field specific thing). My view that the profession is slanted right compared to the evidence just means I am to the left of most of the profession.

In any case this has almost nothing to do with missing the warning signs.