V. NOBODY COULD HAVE PREDICTED . . .
In recent, rueful economics discussions, an all-purpose punch linehas become “nobody could have predicted. . . .” It’s what you say withregard to disasters that could have been predicted, should have beenpredicted and actually were predicted by a few economists who werescoffed at for their pains.
Take, for example, the precipitous rise and fall of housing prices.Some economists, notably Robert Shiller, did identify the bubble andwarn of painful consequences if it were to burst. Yet key policy makersfailed to see the obvious. In 2004, Alan Greenspan dismissed talk of ahousing bubble: “a national severe price distortion,” he declared, was“most unlikely.” Home-price increases, Ben Bernanke said in 2005,“largely reflect strong economic fundamentals.”
How did they miss the bubble? To be fair, interest rates wereunusually low, possibly explaining part of the price rise. It may bethat Greenspan and Bernanke also wanted to celebrate the Fed’s successin pulling the economy out of the 2001 recession; conceding that muchof that success rested on the creation of a monstrous bubble would haveplaced a damper on the festivities.
But there was something else going on: a general belief that bubblesjust don’t happen. What’s striking, when you reread Greenspan’sassurances, is that they weren’t based on evidence — they were based onthe a priori assertion that there simply can’t be a bubble in housing.And the finance theorists were even more adamant on this point. In a2007 interview, Eugene Fama, the father of the efficient-markethypothesis, declared that “the word ‘bubble’ drives me nuts,” and wenton to explain why we can trust the housing market: “Housing markets areless liquid, but people are very careful when they buy houses. It’stypically the biggest investment they’re going to make, so they lookaround very carefully and they compare prices. The bidding process isvery detailed.”
Indeed, home buyers generally do carefully compare prices — that is,they compare the price of their potential purchase with the prices ofother houses. But this says nothing about whether the overall price ofhouses is justified. It’s ketchup economics, again: because a two-quartbottle of ketchup costs twice as much as a one-quart bottle, financetheorists declare that the price of ketchup must be right.
In short, the belief in efficient financial markets blinded many ifnot most economists to the emergence of the biggest financial bubble inhistory. And efficient-market theory also played a significant role ininflating that bubble in the first place.
Now that the undiagnosed bubble has burst, the true riskiness ofsupposedly safe assets has been revealed and the financial system hasdemonstrated its fragility. U.S. households have seen $13 trillion inwealth evaporate. More than six million jobs have been lost, and theunemployment rate appears headed for its highest level since 1940. Sowhat guidance does modern economics have to offer in our currentpredicament? And should we trust it?