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Defending A Profession: Economists Speak About Crisis

economics panel story thumbnailTo those critics who would fault economists for not predicting the past year’s financial meltdown, three Carnegie Mellon experts have this to say: It’s tougher than it looks.

“I don’t see economics as a precise enough science that our models could have predicted (the crisis),” said Stephen Spear, professor of economics at the Tepper School.

Spear spoke as part of a panel convened by the Undergraduate Economics Department at the school to discuss monetary policy in the wake of the economic crisis that has engulfed the markets since mid-2008. Titled “Is economics relevant? A roundtable discussion of economics as a guide to managing the economy,” the panel also included Marvin Goodfriend, professor of economics and chairman, The Gailliot Center for Public Policy; and Bennett McCallum, H.J. Heinz Professor of Economics. Dennis Epple, Thomas Lord Professor of Economics; and head of the B.S. in Economics Program, moderated the panel.

According to Spear, if economists are guilty of anything, it’s in not standing up forcefully enough to explain that unregulated markets are not always the best way to allocate resources.

Known as the first welfare theorem, the market-first approach has a basis in economics, Spear said, but doesn’t work in the real world, where monopolies and oligopolies create imperfections in competition, information among agents is asymmetrical, and costs and benefits exist that aren’t reflected in prices.

“To simply, blindly assert that free markets are good — that you can never do better than a market mechanism — I think is simply wrong, and we have not said enough about that,” Spear remarked.

To illustrate how difficult it is to predict things like the housing bubble, Goodfriend likes to tell a story: In 1996, Alan Greenspan, then chairman of the Federal Reserve, called equity markets “irrationally exuberant.” Yet the prices went up and stayed up for years.

“I think you have to say Greenspan got that one wrong,” said Goodfriend, who previously worked as chief economist for the Richmond Fed. “He got a lot of publicity for saying that markets were ‘irrationally exuberant,’ but basically, I think he was insufficiently exuberant.”

A decade later, looking at ballooning housing prices, Greenspan took a different approach: He didn’t label that market a bubble, though in hindsight, it clearly was.

“So he managed to get it wrong twice,” said Goodfriend. “The lesson I take (from that example) is how hard it is even for experts to get it right, calling things a bubble.”

In a question-and-answer session with the audience, the group addressed bailouts, the Fed’s involvement in credit policy, and the concept of “too big to fail.”

“The consensus now seems to be that the Fed should have bailed out Lehman Brothers, (and) by not doing so, they completely reversed course,” said McCallum.

But Spear said the real mistake was in allowing investment banks to get as large as they did.

“There is so much at stake in this financial system that you cannot let them fail,” he pointed out. “And if they know that you can’t let them fail, there is a huge moral hazard problem.”

Goodfriend has a solution: When deciding whether a bailout is a good idea, put the taxpayer in the loop.

Under the current system, with the Federal Reserve acting independently on a politically charged decision, the central bank is backed into a corner, said Goodfriend. His idea is to start a systemic oversight council in the U.S. Treasury office so the president and Treasury secretary will direct policy on whether bailout loans should be made. Taxpayers are bound to push back, and bankers will no longer believe they are too big to fail, said Goodfriend.

“This is a political problem for our country. The only way to solve it is to make bailouts explicitly political,” he said. “This year’s problem … is almost certain to recur in a much bigger way over the next 10 years or so unless we get out in front of this very problem.” 

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