Lessons From The Current Crisis - Macroeconomics

Economics has been bashed thoroughly, by me, and loads of other commentators for failing to be remotely useful in predicting or solving this current crisis. Is it totally useless? To be fair, many of the economic concepts and ideas are useful in addressing and commenting on business issues and strategies, even till today. Its problem is its predictive element and is it still relevant?

In Businessweek International, they had 3 economists to share their insights on lessons from the current crisis:

1) Hyun Song Chin, Princeton University - He thinks that the Fed should pop credit bubbles early by raising interest rates. Shin faults macroeconomists for developing models that didn't allow for the possibility of risks such as a bubble in lending or deterioration of credit standards.

2) Roger Farmer, UCLA - He thinks that the Fed should make large scale purchases of equities to restore investor confidence and get the economy back on track. He thinks that the Obama's administration doing that would be more effective than deficit spending. He frets that if the government puts more money in the public's pockets via spending or tax cuts, people won't spend it as long as they feel poor because of stock market losses. Similar ideas have been tried before in HK, Taiwan and Japan - but had been relatively effective in HK and Taiwan.

3) Thomas Sargent, NYU - To him, the economy is volatile because households and businesses hold fragile beliefs that shift quickly. In the 70s Sargent stood by "rational expectations" which says that ordinary people can correctly anticipate the range and likelihood of possible future outcomes. He now thinks that theory was oversimplification. In real life, households and businesses are highly uncertain. These fragile beliefs though may shift back positively again through unexpected positive events.

In my view, macroeconomics has failed to predict or solve this crisis because:

a) the models are not sophisticated enough. They did not have the capacity to assess the "effects of derivatives", how the leveraged balance sheets (or rather off balance sheet items) pumps liquidity through the system, and the consequences when this liquidity is eroded.

b) the assumption of the "rational man" is flawed, I totally agree with the "fragile beliefs man" theory. That being the case, the importance of "confidence" in expectations has been understated, and maybe difficult to be incorporated into models.

c) the assumption that the markets is efficient is again flawed, apparently markets are not efficient but rather random and unpredictable, and will have extended periods where the markets can be totally inefficient.


p/s photo: Suki Chui Suk Mun & Shirley Yeung Si Kei