Noted Harvard economist Greg Mankiw wrote an op-ed last week for the New York Times and posted to his blog, a letter to the president-elect. One of his recommendations was to listen to economists. Following up on Steve Hsu's post on intellectual honesty, I think this exhibits an element of hubris since the majority of economists did not foresee this current financial meltdown. There were certainly those that were warning about the collapse of the housing bubble, like Robert Shiller, but other than Nouriel Roubini, I didn't hear too much about it causing the worst crisis since the Great Depression. Even Paul Krugman admits that this took him by surprise. I could see that there was a housing bubble back in 2004, which is why I haven't bought a house yet, but I had no idea that the bursting of a bubble could cause so much damage. The bursting of the internet bubble caused a lot of pain to some people but did not destroy the financial system.
The current crisis first became public knowledge when Bear Stearns went under in March of this year. Federal Reserve Chairman Ben Bernanke quickly engineered a buy out of Bear by JPMorgan and the market calmed for a while. Then in quick succession starting in September came the bailout of Fannie Mae and Freddie Mac, the sale of Merrill Lynch to Bank of America, the bankruptcy of Lehman Brothers, and the bailout of A.I.G. Shortly afterwards, Treasury Secretary Hank Paulson went to Congress to announce that the entire financial system is in jeopardy and requested 700 billion dollars for a bail out. The thinking was that banks and financial institutions had stopped lending to each other because they weren't sure which banks were sound and which were on the verge of collapse. The money was originally intended to purchase suspect financial instruments in an attempt to restore confidence. The plan has changed since then and you can read Steve Hsu's blog for the details.
What I want to point out here is that a narrative of what happened is not the same as understanding the system. There were certainly a lot of key events and circumstances starting in the 1980's that may have contributed to this collapse. There was the gradual deregulation of the financial industry including the Gramm-Leach-Bliley Act in 1999 that allowed investment banks and commercial banks to coalesce and the Commodity-Futures-Modernization Act in 2000 that ensured that financial derivatives remained unregulated. There was the rise of hedge funds and the use of massive amounts of leveraging by financial institutions. There were low interest rates following the internet bubble that fueled the housing bubble. There was the immense trade deficit with China (and China's interest in keeping the US dollar high) that allowed low interest rates to persist. There was the general world savings glut that allowed so much capital to flow to the US. There was the flood of physicists and mathematicians to Wall Street and so on.
Anyone can create a nice story about what happened and depending on their prior beliefs they can be dramatically different - compare George Soros to Phil Gramm. We really would like to understand in general how the economy and financial markets operate but we only have one data point. We can never rerun history and obtain a distribution of outcomes. Thus, although we may be able to construct a plausible and consistent story for why an event happened we can never know if it were correct and even more importantly we don't know if that can tell us how to prevent it from happening again. It could be that no matter what we had done, a crisis would still have ensued. My father warned of a collapse of the capitalistic system his entire life. I'm not sure how he would have felt had he lived to see the current crisis but he probably would have said it was inevitable. Or perhaps, if interest rates were a few points higher nothing would have happened. The truth is probably somewhere in between.
Another way of saying this is that we have a very large complex dynamical system and we have one trajectory. What we want to know about are the attractors, the basins of attraction, and the structural stabilty of the system. These are things that are difficult to determine even if we had full knowledge of the underlying dynamical system. We are trying to construct the dynamical system and infer all these properties from the observation of a single trajectory. I'm not sure if this task is impossible (i.e. undecidable) but it is certainly intractable. I don't know how we should proceed but I do know that conventional economic dogma about efficient markets needs to be updated. Theorems are only as good as their axioms and we definitely don't know what the axioms are for sure. I think the sooner economists own up to the fact that they really don't know and can't know what is going on, the better we will be.