Predicting Financial Crises: Are Macroeconomic Models Useful?

There has been no shortage of effort devoted to predicting earthquakes, yet we still can't see them coming far enough in advance to move people to safety. When a big earthquake hits, it is a surprise. We may be able to look at the data after the fact and see that certain stresses were building, so it looks like we should have known an earthquake was going to occur at any moment, but these sorts of retrospective analyses have not allowed us to predict the next one. The exact timing and location is always a surprise.

Does that mean that science has failed? Should we criticize the models as useless?

No. There are two uses of models. One is to understand how the world works, another is to make predictions about the future. We may never be able to predict earthquakes far enough in advance and with enough specificity to allow us time to move to safety before they occur, but that doesn't prevent us from understanding the science underlying earthquakes. Perhaps as our understanding increases prediction will be possible, and for that reason scientists shouldn't give up trying to improve their models, but for now we simply cannot predict the arrival of earthquakes.

However, even though earthquakes cannot be predicted, at least not yet, it would be wrong to conclude that science has nothing to offer. First, understanding how earthquakes occur can help us design buildings and make other changes to limit the damage even if we don't know exactly when an earthquake will occur. Second, if an earthquake happens and, despite our best efforts to insulate against it there are still substantial consequences, science can help us to offset and limit the damage. To name just one example, the science surrounding disease transmission helps use to avoid contaminated water supplies after a disaster, something that often compounds tragedy when this science is not available. But there are lots of other things we can do as well, including using the models to determine where help is most needed.

So even if we cannot predict earthquakes, and we can't, the models are still useful for understanding how earthquakes happen. This understanding is valuable because it helps us to prepare for disasters in advance, and to determine policies that will minimize their impact after they happen.

All of this can be applied to macroeconomics. Whether or not we should have predicted the financial earthquake is a question that has been debated extensively, so I am going to set that aside. One side says financial market price changes, like earthquakes, are inherently unpredictable -- we will never predict them no matter how good our models get (the efficient markets types). The other side says the stresses that were building were obvious. Like the stresses that build when tectonic plates moving in opposite directions rub against each other, it was only a question of when, not if.

(But even when increasing stress between two plates is observable, scientists cannot tell you for sure if a series of small earthquakes will relieve the stress and do little harm, or if there will be one big adjustment that relieves the stress all at once. With respect to the financial crisis, economists expected lots of little, small harm causing adjustments, instead we got the "big one," and the "buildings and other structures" we thought could withstand the shock all came crumbling down. On prediction in economics, perhaps someday improved models will allow us to do better than we have so far at predicting the exact timing of crises, and I think that earthquakes provide some guidance here. You have to ask first if stress is building in a particular sector, and then ask if action needs to be taken because the stress has reached dangerous levels, levels that might result in a big crash rather than a series of small stress relieving adjustments. I don't think our models are very good at detecting accumulating stress, in large part because when we are not at the long-run equilibrium, we model the short-run as though every market clears at every point in time. This means that there are no stresses continuously building in these models, the adjustments always relieve the stress and move us back toward long-run equilibrium. We have to do a better job of allowing for the build up of stress within our models, and then using these models to guide the measurement and monitoring of "stress levels" in particular markets, particularly asset markets, so we can take action when the levels are too high.)

Whether the financial crisis should have been predicted or not, the fact that it wasn't predicted does not mean that macroeconomic models are useless any more than the failure to predict earthquakes implies that earthquake science is useless. As with earthquakes, even when prediction is not possible (or missed), the models can still help us to understand how these shocks occur. That understanding is useful for getting ready for the next shock, or even preventing it, and for minimizing the consequences of shocks that do occur.

But we have done much better at dealing with the consequences of unexpected shocks ex-post than we have at getting ready for these a priori. Our equivalent of getting buildings ready for an earthquake before it happens is to use changes in institutions and regulations to insulate the financial sector and the larger economy from the negative consequences of financial and other shocks. Here I think economists made mistakes - our "buildings" were not strong enough to withstand the earthquake that hit. We could argue that the shock was so big that no amount of reasonable advance preparation would have stopped the "building" from collapsing, but I think it's more the case that enough time has passed since the last big financial earthquake that we forgot what we needed to do. We allowed new buildings to be constructed without the proper safeguards.

However, that doesn't mean the models themselves were useless. The models were there and could have provided guidance, but the implied "building codes" were ignored. Greenspan and others assumed no private builder would ever construct a building that couldn't withstand an earthquake, the market would force them to take this into consideration. But they were wrong about that, and even Greenspan now admits that government building codes are necessary. It wasn't the models, it was how they were used (or rather not used) that prevented us from putting safeguards into place.

We haven't failed at this entirely though. For example, we have had some success at putting safeguards into place before shocks occur, automatic stabilizers have done a lot to insulate against the negative consequences of the recession (though they could have been larger to stop the building from swaying as much as it has). So it's not proper to say that our models have not helped us to prepare in advance at all, the insulation social insurance programs provide is extremely important to recognize. But it is the case that we could have and should have done better at preparing before the shock hit.

I'd argue that our most successful use of models has been in cleaning up after shocks rather than predicting, preventing, or insulating against them through pre-crisis preparation. When despite our best effort to prevent it or to minimize its impact a priori, we get a recession anyway, we can use our models as a guide to monetary, fiscal, and other policies that help to reduce the consequences of the shock (this is the equivalent of, after a disaster hits, making sure that the water is safe to drink, people have food to eat, there is a plan for rebuilding quickly and efficiently, etc.). As noted above, we haven't done a very good job at predicting big crises, and we could have done a much better job at implementing regulatory and institutional changes that prevent or limit the impact of shocks. But we do a pretty good job of stepping in with policy actions that minimize the impact of shocks after they occur. This recession was bad, but it wasn't another Great Depression like it might have been without policy intervention.

Whether or not we will ever be able to predict recessions reliably, it's important to recognize that our models still provide considerable guidance for actions we can take before and after large shocks that minimize their impact and maybe even prevent them altogether (though we will have to do a better job of listening to what the models have to say). Prediction is important, but it's not the only use of models.

Comments

[Clive Corcoran:]

"On prediction in economics, perhaps someday improved models will allow us to do better than we have so far at predicting the exact timing of crises."

There is something inherently counter-intuitive about predicting economic crises. If we "know" when one is coming it will come sooner rather than later as nobody will wait for the actual predicted date to arrive. They will either become self-fulfilling and happen sooner or avoidance tactics will prevent them happening on the specified dates.

While it certainly would be good to be able to predict earthquakes and other natural disasters there would seem to be a fundamental disconnect between the geo-sciences and those that deal with human behavior

Aug 26 08:22 AM

[The Geoffster:]

The financial markets are based on trust. They are essentially a con game. As long as people have confidence in the markets, credit flows. That confidence is now being supported by the Fed with massive liquidity. Unfortunately, the underlying fault lines have not been fixed and more stress is building up below.

Aug 26 08:40 AM

[socrateazz:]

Interesting. The analogy seems reasonable. But I think you are calling a minor earthquake a major one. A little damage was done and much of it repaired by puting bandaids in place. I think instead of improving the foundation of the economy, thousands of strings were tied between the supports to save the weak supports. As long as a big one does not hit soon, then the structure could be saved. If more weight is tied to the current supports without strengthing the economies foundation then expect the worst. Any support could buckle and come tumbling down on this economy. I hope I am wrong!

Aug 26 08:51 AM

[Tom Armistead:]

Asset bubbles create "tectonic stress" between market prices and realistically sustainable values. As the author notes, macroeconomic models can identify these stresses. Doing so would require a view of long term average values as more important than current values.

As far as predicting whether stresses would be relieved by a series of minor jolts or one big one, that is more difficult, as noted. Those whose business activities made them aware of the amount of fraud at all links in the real estate sale/mortgage origination/securitiza... chain could easily have predicted what occurred, and some did. Some of the evidence no doubt was anecdotal, war stories told at cocktail parties.

Economists come in thre skill levels: 1) those who wonder what happened, 2) those who can tell you what happened, and 3) those who can tell you what is going to happen. Economists who aspire to be in the 3rd group will need to network into the area of asset bubbles, get to know industry participants, and develop methods to test the pervasiveness of problems that first appear as anecdotal evidence.

Aug 26 09:27 AM

[conceptwizard:]

You would have to believe that the FED did not know what they were doing under Greenspan when he kept interest rates low and easy credit terms to fuel this monstrous bubble. If they are this unaware of their actions and the consequences then we are all doomed.

I believe that they knew perfectly well what the outcome of FED policy would be.

Aug 26 09:51 AM

[pungent:]

I think a better analogy is a munitions factory. Based on the amount of high explosives being employed to manufacture weapons of mass (financial) destruction, the owner should employ ever greater safeguards; safety procedures, blast-proof walls, etc. In our case, the owners of the largest factories redirected the funds for thicker walls to build even larger weapons. When the inevitable happened, the walls blew out hitting neighboring factories; munitions and otherwise. Yes, this was highly predictable -- just ask Buffett (see Financial Times, 04Mar2003). Brilliantly, the politicians (mostly with backgrounds and cronies in the same industry) chose to support and reward this deliberate negligence.

Aug 26 10:06 AM

[nym:]

As the New Yorker used to comment, "Block that metaphor!"

Aug 26 10:14 AM

[Tony Petroski:]

The voice of science:

"The models were there and could have provided guidance, but the implied "building codes" were ignored. Greenspan and others assumed no private builder would ever construct a building that couldn't withstand an earthquake."

Mr. Thoma. Keep going.

As for me, I'm operating on the assumption, science or not, that earthquakes and the timing of them are up to someone else.

Aug 26 12:53 PM

[TinyTim:]

Models are for explaining and predicting.
Macro models can explain OK but don't predict.

Macro models can be used to make changes that fortify the system.
You have a lot more confidence in economics and the system than I do.

Aug 26 04:09 PM

[Teutonic Kn...:]

To Mark Thomas - - -

As a graduate practicing engineer with several decades of experience, and quoting the remarks of an MIT PhD colleague, "...all modeling and simulations have failed...".

To be truthful and fair though, some form of modeling and simulating for designing and constructing a blender or a toaster appliance might prove useful. But if you are talking about modeling human behavior, particularly alike of the kind of economic and financial types that you are alluding to here, my view of their worth might be next to Voodoo.

TK

Aug 26 11:28 PM

[Dirtnap:]

As a research assistant in the field of modeling electromagnetic behavior, I can attest to the fact that it is much more realistic to model physical effects which are inalterably governed by laws which cannot be changed - only understood. Modeling economics during nominal behavior may be achievable, but during a crisis there are simply too many effects to account for, because the rules keep changing.

A model of aggregate human behavior may never be possible.

Aug 27 12:30 AM