Saturday, January 14, 2012

News flash: Bernanke not clairvoyant

Last week was full of the shocking revelations in newly released Fed minutes. Bernanke and co. didn't foresee the housing crash and banking crisis! See coverage in the New York Times and Wall Street Journal.

The Times can barely conceal its "how stupid were they" glee.
The officials laughed about the cars that builders were offering as signing bonuses, and about efforts to make empty homes look occupied. ...But the officials...gave little credence to the possibility that the faltering housing market would weigh on the broader economy,... Instead they continued to tell one another throughout 2006 that the greatest danger was inflation...
Justin Wolfers says the lack of foresight is "embarrassing," 
“It’s embarrassing for the Fed,” said Justin Wolfers, an economics professor at the University of Pennsylvania. “You see an awareness that the housing market is starting to crumble, and you see a lack of awareness of the connection between the housing market and financial markets.”
“It’s also embarrassing for economics,” he continued. “My strong guess is that if we had a transcript of any other economist, there would be at least as much fodder.”
(I hope for Justin's sake that his quotes were as usual mangled and taken out of context.)

The Journal piles on. Cassandras were ignored: "A handful of Fed officials warned of trouble brewing." The other "Fed officials were expecting a manageable slowdown in the housing sector, with little damage to the financial system or broader economy." And heavens, they even had "praise for outgoing Fed Chairman Alan Greenspan."

Well, that was fun. But what's the point, dear Times? We just need to put "smarter" people in charge and all will be well?

The real lesson is this: The smartest people in the room didn't -- couldn't -- see it coming. The smartest people in the room won't see the next one coming either.  

Nobody can systematically predict the financial future a lot better. If they could, they'd be rich enough to bail out the National Debt.

Sure, some people warned of this event.  But half of them won't see the next one. The other half have already predicted 5 more crises that never happened. The project "we'll just find someone a lot smarter or wiser than Ben Bernanke" is hopeless!

It's not embarrassing to my economics. The main prediction of market efficiency is precisely that nobody can systematically see market movements and bank runs ahead of time. Efficient markets are not clairvoyant markets. That prediction seems rather brilliantly confirmed!

This matters. We have doubled down on the idea that we can appoint All Powerful Regulators to  presciently spot "bubbles" and "imbalances" before private forecasters and the harsh judgment of financial markets do so, and then regulate away the risks. This strategy has already failed at least three times, after the crisis: The SEC didn't notice Bernie Madoff; the CFTC didn't stop Jon Corzine, and the entire European bank regulatory apparatus failed to notice that sovereign debt might be risky.

This story is embarrassing, yes. But it's most embarrassing for the Times and other believers in the idea of clairvoyant, all-powerful discretionary regulators. It's not at all embarrassing if you think Fed officials are as human as the rest of us -- and that safety comes from better rules of the game, not finding just the right soothsayer to run the show.