Rebuttal to Colander, Hass, Juselius, Lux, Follmer, Goldberg, Kirman, and Sloth

I was catching up on the blogs that I follow and came across a link to a research paper on naked capitalism. The paper is entitled "The Financial Crisis and the Systemic Failure of Academic Economics" and is co-authored by all those listed in the long title to this post.

First off, I have to agree with the fact that most all models used in practice to assess risk, hedge portfolios, and understand the economy are dangerous. They are dangerous in the sense that the models are built on assumptions which may hold true most of the time, but fail to be true all of the time. In fact, this has been a contributing factor to some of the systemic risk which has crippled the financial and economic system.

However, I can't agree with a statement like this:

In our view, economists, as with all scientists, have an ethical responsibility to communicate the limitations of their models and the potential misuses of their research. Currently, there is no ethical code for profession economic scientists. There should be one. [emphasis theirs]

This is a very arrogant statement. I think it is a stretch to refer to economists as scientists - especially macroeconomists. I'll concede that in a strict sense of the definition, economists are scientists. But, the public view of "scientist", especially when it comes to those using numbers, allows for a gross overstatement in the applicability of economic science. Regardless, I cannot agree with any statement which implies that there is some sort of higher moral and ethical standard which individuals should have to apply to their trade. If you don't agree with that statement, then ask yourself who decides what is moral and ethical?

The article also states other research:

The most recent literature provides us with examples of blindness against the upcoming storm that seem odd in retrospect. For example, in their analysis of the risk management implications of CDOs, Krahnen (2005) and Krahnen and Wilde (2006) mention the possibility of an increase of 'systemic risk.' But, they conclude that this aspect should not be the concern of the banks engaged in the CDO market, because it is the governments' responsibility to provide costless insurance against a system-wide crash.

Bingo! Banks very well may have recognized the systemic risk that was running through the system due to exotic derivatives such as CDOs (collateralized debt obligations - packaged debt products which shifted risk from lenders to investors). But, as is clearly stated, banks felt they could engage in these risky products because they perceived that the government would insure massive losses. Hmm... looks like perception has become reality. The authors ignore this basic reality in the rest of the paper and instead argue that economic and financial models are to blame for the crisis. It appears to me that if banks and investors did not have an implicit or explicit guarantee against massive risks, they would have behaved differently.

Finally, the authors state the following in their conclusion:

The current crisis might be characterized as an example of the final stage of a well-known boom-and-bust pattern that has been repeated so many time in the course of economic history... Research on the origins of instabilities, overinvestment and subsequent slumps has been considered as an exotic side track from the academic research agenda... because it was incompatible with the premise of the rational representative agent.

The Austrian School of economics offers a simple explanation of the boom-and-bust cycle which the authors feel is either elusive or not well understood. The Austrian School points directly to the statements I have noted above and briefly mentioned by the authors. Government intervention via interest rate manipulation, control of the money supply, explicit subsidies and implicit guarantees drives malinvestment - including, as the authors state, "overinvestment". It is difficult to infer if this paper is providing a small tip-of-the-hat to the Austrian School or is feigning willful ignorance of their free-market explanations. Given that no Austrian economist is mentioned in the paper, the authors' call for more regulation, and their views against the principles of rational actors, I would have to surmise that the authors simply seek to ignore the Austrian School and implore mainstream economic academics to do the same in a search for an alternate, government-friendly, explanation.