Monday, January 7, 2013

In New Paper, Professor Thoma Overlooks The Contribution of Financial Bloggers

Professor Thoma has a new paper coming out which highlights that bad advice and the herd mentality can hurt prognostication.  Here are some salient points from the summary available on his website:

The belief that housing prices would continue to rise into the foreseeable future was an important factor in creating the housing price bubble. But why did people believe this? Why did they become convinced, as they always do prior to a bubble, that this time was different? One reason is bad advice from academic and industry experts. Many people turned to these experts when housing prices were inflating and asked if we were in a bubble. The answer in far too many cases – almost all when they had an opinion at all – was that no, this wasn’t a bubble. Potential homebuyers were told there were real factors such as increased immigration, zoning laws, resource constraints in an increasingly globalized economy, and so on that would continue to drive up housing prices.

When the few economists who did understand that housing prices were far above their historical trends pointed out that a typical bubble pattern had emerged – both Robert Shiller and Dean Baker come to mind – they were mostly ignored. Thus, both academic and industry economists helped to convince people that the increase in prices was permanent, and that they ought to get in on the housing boom as soon as possible.

But why did so few economists warn about the bubble? And more importantly for the model presented in this paper, why did so many economists validate what turned out to be destructive trend-chasing behavior among investors?
One reason is that economists have become far too disconnected from the lessons of history. As courses in economic history have faded from graduate programs in recent decades, economists have become much less aware of the long history of bubbles. This has caused a diminished ability to recognize the housing bubble as it was inflating. And worse, the small amount of recent experience we have with bubbles has led to complacency. We were able to escape, for example, the stock bubble crash of 2001 without too much trouble. And other problems such as the Asian financial crisis did not cause anything close to the troubles we had after the housing bubble collapsed, or the troubles other bubbles have caused throughout history. 

A second factor is the lack of deep institutional knowledge of the markets academic economists study. Theoretical models are idealized, pared down versions of reality intended to capture the fundamental issues relative to the question at hand. Because of their mathematical complexity, macro models in particular are highly idealized and only capture a few real world features such as sticky prices and wages. Economists who were intimately familiar with these highly stylized models assumed they were just as familiar with the markets the models were intended to represent. But the models were not up to the task at hand,[1] and when the models failed to signal that a bubble was coming there was no deep institutional knowledge to rely upon. There was nothing to give the people using these models a hint that they were not capturing important features of real world markets.

Let me respond to these observations from the perspective of a financial and economic blogger.

First -- a large number of financial bloggers called the housing market before the "accredited" economists.  Mish (who has since regrettably lost his mind), Calculated Risk, Barry Ritholtz and yes, Bonddad and NDD all called the bubble and have also been pretty good at predicting the trajectory and magnitude of the recession and the recovery.  I realize that because we're not the "super cool people who have economics PhDs after their name," we probably get overlooked by the accredited economists who have such a magnificent prognostication record, but you would think that being right most of the time in our analysis would actually count for something in Professor Thoma's statement.

Going back to the housing bubble, I originally saw the problem from the buyers side.  The massive accumulation of household debt -- which eventually rose to 137% of real disposable income at the national level -- literally popped out at me as being horribly out of line (I also remember supplying Barry Ritholtz with this and other data in an online debate with Donald Luskin).  The chart of the data indicated this was an unprecedented level of debt by historical standards.  That got me thinking about income and job growth for the last recovery -- which was actually also fairly weak by historical standards -- and, then putting those two figures (high debt plus weak income and job growth) together.  There were also charts of residential investment as a percentage of GDP which showed a seriously out-of-whack sector.  Finally, at some some, the Case Shiller index came out and clearly showed that prices were extremely out of balance by all standards.

Others (Mish, CR, Barry, The Mess that Greenspan Made etc..) took different tacks, but all came up with the same conclusion: there was a housing bubble, it was very large, and there were serious problems associated with it.

That leads to the question of why were the financial bloggers right when the highly venerated economists -- those who Professor Thoma focuses on -- were so wrong?  Exactly for not being subject to the two exceptions Thoma points out.  

First, when you read people like Calculated Risk and us, you'll see that we usually try and present long data series to see how data has performed.  I usually try and use as much of the post WWII history as is available; the same is true of Calculated Risk.  Barry is notorious for going back centuries.  I should also add that -- thanks to advice from Professor Thoma -- I've read a fair amount of economic history like the classic texts of Smith, Say, Mill, Fisher, Marshall an Keynes.   

Secondly, unlike academics, most of us sit or have sat at computer screens analyzing data as it comes across the news wire and have had to figure out what that means for the markets we follow and invest in.  Put another way, we're not slaves to a model that may or may not work.  Instead, we're trying to make money -- or at minimum not lose it.  In comparison, most economists are slaves to a perspective, not data.  Art Laffer comes to mind -- I'm still waiting for his admission that his call for a massive spike in inflation was horribly wrong -- as does John Cochrane at the University of Chicago (has he ever sat in front of a trading screen and tried to out his knowledge to the test)?  

So, while Professor Thoma is correct in pointing out the most economists just aren't that good from the practical side of things (as in, explaining what's really going on), he could also highlight the fact that there is a not insubstantial group of us with a tremendous amount of financial and economic knowledge that did get it right -- and continue to get it right pretty consistently.  While we're not "economists" in the formal sense, our lack of "formal" economic accreditation -- and emphasis on real world application -- has made us far more accurate than many in the ivory towers of academia.