Economic Theory Useless for Real Economy

We have the biggest economic crisis in 80 years, yet most economists were admittedly clueless about the cause of the crisis

Should economists and policy makers have identified the housing market bubble before it burst? The answer is most likely no, says the Federal Reserve Bank of Boston, because economic theory was not up to the challenge.

“Economic theory provides little guidance as to what should be the ‘correct’ level of asset prices — including housing prices,” the new paper published by the bank says. It was written by economists Kristopher Gerardi, Christopher Foote and Paul Willen.

“While optimistic forecasts held by many market participants in 2005 turned out to be inaccurate” those projections were not “unreasonable” given what was understood about the economy and housing market dynamics in the years before housing prices crashed and helped create one of the worst economic downturns in generations. ...

In other words, they did not understand much about the economy nor the housing market.

The paper notes economists were clearly not of one mind about the implications of rising housing prices. Some saw them as consistent with economic fundamentals, and driven by factors like the need for shelter to house a growing population, a favored explanation of central bankers themselves during those years. Others simply punted, offering no view.

Then there were those with negative views, many of whom have been sharply critical of the economics profession, and of policy makers.

“The pessimistic case was a distinctly minority view, especially among professional economists,” the paper observed. “The small number of economists who argued forcefully for a bubble often did so years before the housing market peak, and thus lost a fair amount of credibility” in the process. Others called a bubble with “arguments fundamentally at odds with the data” that became available after the fact, the economists write.

The fact that a small number of economists who saw this coming but lost credibility because the peak was still some time away says more about the economics profession than it does about those who saw the crisis coming but were early. 

That paper notes that for the most part, regardless of the view economists held on housing, the science of economics wasn’t really even equipped to deal with the issue. “Academic research available in 2006 was basically inconclusive and could not convincingly support or refute any hypothesis about the future path of asset prices.” That meant anyone could argue anything. [Emphasis added]

Yes, anyone could make any argument and no one had any idea if they were right or wrong.  That is quite the "science," isn't it?

Of course, not all economic theory is useless.  However, as a profession which attempts to add value through forecasting, it fails at the most critical times, which is tantamount to a meteorologist who consistently forecasts sunny skies with the occasional rain but is unable to see the hurricane coming.

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