Why Did So Many Economists Fail To Predict The Crash?

Economics, economic models and economists were all surprised by the global financial crash of 2008, as their predictions of what was about to happen were embarrassingly absent. Since then some economists have continued to ignore the problem, others have carried on with little change in their thinking, while an enlightened few search for solutions.

Economic categories

Economics is often divided into two categories: macroeconomics and microeconomics. Macroeconomics focuses on the entire economy while microeconomics focuses on the everyday decisions made by individuals, companies and markets.

Macroeconomics looks at how the economy performs and considers indicators such as the level of employment and unemployment, the rate of interest and the level of government spending.

Microeconomics looks at the performance of smaller indicators and measures the effects of decisions by individuals, families and businesses on the marketplace.

Many economists still cling to the traditional financial mathematical models that failed to predict the crash and, surprisingly, still win Nobel prizes.

Surprising not only because traditional macroeconomic models failed to predict the financial crash but also because they have been of little help in delivering any aspect of the recovery.

Perhaps not too surprising though because the models that failed to capture what was happening even with individual and bank debt relied on flawed assumptions based on rational and predictable human behaviour.

That was, let’s not forget, at a time when there was nothing rational or predictable about the way people or, indeed, the banking or regulation system was behaving.

Hope is in the air

There is, however, hope as some more progressive economic thinkers try to understand what happened, why it happened and how to avoid a similar crash in the future.

In an effort to explain what went wrong they are revisiting economic history to look for clues as to why the crash was not predicted or avoided or at least managed in a better way.

Other economists are reaching outside their traditional boundaries to work with other disciplines such as psychology to look at the effect of people’s behaviour on economic models and the actions of the market.

The way forward, of course, is to capture the best of the traditional economic financial models and combine them with new thinking and a better understanding of how people and markets behave in reality.

Regardless of the approach taken by individual economists, however, economics needs to change its approach if it is to reflect what happens today and what will happen in the future.

In essence, economics and economic education must engage with other disciplines, learn from its roots, be more aware of the actual behaviour of so called rational actors, and realise that people and markets are imperfect and uncertain by their nature.

So, the vast majority of economists failed to predict the great financial crash and will fail again unless they reshape their thinking to better reflect the real economy.