The Post gave an excellent illustration of how the economics profession managed to almost completely miss the housing bubble and the inevitable disaster that would be caused by its collapse. An article on Greenspan's acknowledgment that he made some mistakes cites Frederick Mishkin, a Columbia University professor and former Federal Reserve Board governor. Mishkin is an interesting person to turn to as an authority. In 2006, Mr. Mishkin did an analysis of Iceland's economy in which he concluded that "the sources of financial instability that triggered financial crises in emerging market countries in recent years just are not present in Iceland." At the time, Iceland had a current account deficit of 15 percent of GDP. The report claimed that this deficit was not necessarily a big problem, arguing that Iceland's system of inflation targeting provided the stability that allowed it to sustain current account deficits of this magnitude. In the current economic crisis, Iceland's economy has been hit harder than any other wealthy country. Its banking system has completely collapsed and it has been desperately seeking a bailout from Russia or the IMF. It would be difficult to imagine someone being more wrong about Iceland's economy than Mr. Mishkin, yet this does not damage his standing in the profession at all. Unlike custodians, cab drivers, or dishwashers, economists are not held accountable for their job performance. They can be wrong on everything they do every day of the week, and still be viewed as respected authorities by the Washington Post, and other media outlets, as well as members of Congress and others in policy positions. This fact also supplies the answer to Alan Greenspan's claim that explosive situations like the housing bubble could not be seen: "The Federal Reserve had as good an economic organization as exists ...If all those extraordinarily capable people were unable to foresee the development of this critical problem . . . we have to ask ourselves: Why is that? And the answer is that we're not smart enough as people. We just cannot see events that far in advance." In fact, the problem is not that "we" cannot see events that far in advance. The problem is that the Federal Reserve Board and the economics profession as a whole functions more like a fraternity than a real forum for debate and truth seeking. Those whose views are taken seriously mimic the views of those with status and power within the profession, they do not think independently. The failure of the economics profession to recognize the bubble and the harm that it would cause was due to the sociology of the profession. For any competent economist, the bubble was easy to see and the damage that its collapse would cause was entirely predictable. [Thanks to Tom Schlesinger at the Financial Markets Center for calling my attention to Mishkin's work on Iceland.]
--Dean Baker [addendum: In response to some comments down below, it is true that, while I did comment from time to time on the financial havoc that would result from the collapse of the housing bubble, I did not highlight this issue. (My first warning that Freddie and Fannie would likely go under was in September of 2002.) There were two reasons that I did not highlight the financial crisis. First, even in the best of times housing is a highly leveraged asset, with buyers typically borrowing 80-90 percent of the purchase price. Of course it became much more highly leveraged during the bubble. When you lose $8 trillion in a highly leveraged asset, it is almost inconceivable that the lenders will not take a big hit. I didn't feel that much need to highlight this fact, since it seemed pretty obvious. The main issue was establishing that there was a housing bubble. I had to contend with Alan Greenspan and just about the whole economics profession on this point. If I got anyone to concede that there was a serious housing bubble, it would not take much convincing to get them to believe that it would result in very serious financial problems when it burst. The second reason that I did not highlight the financial crisis is that one tends to sound shrill in raising such issues. It is comparable to warning about the risk of school fires and repeatedly saying "children will die!" People understand that if there is a school fire, that children are likely to die and they should also understand that if an $8 trillion housing bubble crashes that the banks will take a really big hit. So, I tried my best to calmly focus on the risk of school fires, I doubt that I would have had more impact if I had been yelling about an impending financial crisis for the last 6 years.]
