Sunday, 9 August 2009

Because, Your Majesty, no one could predict it

Queen Elizabeth famously asked why economists did not predict the financial crisis. The best answer I have seen so far comes from Bill Easterly, who offers us the Idiot’s Guide to answering the Queen. Easterly writes,
First, Your Majesty, economists did something even better than predict the crisis. We correctly predicted that we would not be able to predict it. The most important part of the much-maligned Efficient Markets Hypothesis (EMH) is that nobody can systematically beat the stock market. Which implies nobody can predict a market crash, because if you could, then you would obviously beat the market. This applies also to other asset markets like housing prices. If you think it is useless to be told you cannot predict the market, then you should change your Palace investment advisor. This knowledge will protect you from a lot of investment scams like Mr. Madoff’s and will also provoke a serious discussion of how to protect your Royal Wealth against risk in an uncertain world.

Second, economists did just fine pointing to fundamentals that were creating large risks of a financial crisis. Even an outsider like me heard long before the crisis hit about the dangers of opaque instruments like derivatives, excessive mortgage lending and leverage, and the bubble in housing prices. Economists have contributed a lot to understanding bubbles, but we can’t time exactly when they will burst (see EMH above).
Easterly ends his guide by suggesting,
So please tell your subjects in poor countries to keep studying basic mainstream economics. This economics not only survived the crisis, it also is the proven set of ideas that get countries out of poverty.
Well said that man.

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