Raghuram Rajan recently offered three explanations for the failure of economists to anticipate the worst financial crisis since the Great Depression—specialization, the difficulty of forecasting and the disengagement of the profession from the real world.
The systemic failure in the economics profession has done much damage. The Independent Evaluation Office of the International Monetary Fund (IMF) last week released an honest report on why the global central bank failed to foresee the coming crisis during 2004-07. The evaluation cites reports prepared by IMF economists and statements by senior officials that in hindsight seem almost comic.
The World Economic Outlook was merrily painting a rosy picture of the global economy, right up to April 2007, when the harsh truth about subprime mortgages was already out and the first financial shocks were less than four months away. The April 2007 IMF report said that “world growth will continue to be strong” and that global economic risks had declined since September 2006. IMF’s opinion in July 2008 was that “risks of a financial tail event have eased”!
Shredding the IMF analyses with retrospective wisdom is an effortless task. More important are the reasons for its analytical failures. The Independent Evaluation Office nails the real problems, including deadening groupthink (rather than honest opinion) and intellectual capture. The incentives within IMF are such that nobody wants to stick his neck out, which ensures that views tend to coagulate around a consensus and advice becomes procyclical.
Country staff reports tend to be in line with what the governments want, a failing on a par with the more well-known tendency of equity analysts, credit rating agencies and journalists to abandon autonomy so that they can get close to the companies they have to independently cover. Even here, the power of the rich countries is far more than the others. They can do no wrong and are too smart to tumble into a crisis. Indeed!
The hubristic IMF has been unsparing of its own failures. But the problem is far wider and deeper. Ignoring the sage advice given by F.A. Hayek, that they have only the pretence of knowledge, economists have in recent decades behaved as if they have the omniscience to predict the future with statistical tools. Social realities and behavioural warts have been stripped away for the sake of elegant models that have little relation with the actual world. Meanwhile, economists have responded to incentives and sought to impress the powerful just as people in other professions do.
So, a little scepticism could be useful the next time you read a government, academic or investment bank report on the Indian economy!
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