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The Idiot’s Guide to Answering Queen Elizabeth

Queen Elizabeth famously asked why economists did not predict the crisis. I wanted to add to the large chorus of responses, partly to save the reputation of mainstream economics as something still very useful to development, and partly to have a chance to reproduce this photo from my favorite Hollywood comedy The Naked Gun.


I can offer an Idiot’s Guide to answering the Queen because the subject is so far outside my area of specialization within economics, yet even an ignorant outsider like me knows the answer.

First, Your Majesty, economists did something even better than predict the crisis. We correctly predicted that we would not be able to predict it. The most important part of the much-maligned Efficient Markets Hypothesis (EMH) is that nobody can systematically beat the stock market. Which implies nobody can predict a market crash, because if you could, then you would obviously beat the market. This applies also to other asset markets like housing prices. If you think it is useless to be told you cannot predict the market, then you should change your Palace investment advisor. This knowledge will protect you from a lot of investment scams like Mr. Madoff’s and will also provoke a serious discussion of how to protect your Royal Wealth against risk in an uncertain world.

Second, economists did just fine pointing to fundamentals that were creating large risks of a financial crisis. Even an outsider like me heard long before the crisis hit about the dangers of opaque instruments like derivatives, excessive mortgage lending and leverage, and the bubble in housing prices. Economists have contributed a lot to understanding bubbles, but we can’t time exactly when they will burst (see EMH above).

So unlike some of my more venerable economist colleagues who are falling all over themselves apologizing to Your Majesty for OTHER economists (see for example your knighted subject Robert Skidelsky yesterday in the FT), I see nothing for which to apologize.

So please tell your subjects in poor countries to keep studying basic mainstream economics. This economics not only survived the crisis, it also is the proven set of ideas that get countries out of poverty.

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  1. Greg Ransom wrote:

    Things are far worse and far better in economics then you suggest.

    They are far better because there is a small group of economists using advancements in macroeconomic science which allowed them to explain what was happening — systematically the economists who did foresee and explain the bust _in advance_ were using Hayekian macroeconomics — and they did call it. See the work of BIS chief economist William White, financial analysts Kurt Richebächer & Peter Schiff, economists Steve Hanke & Richard Ebeling & Roger Garrison, just for examples.

    Things are far worse in economics because this sort of macroeconomics is blackballed by the “mainstream” of the profession on bogus grounds derived from a failed and scientistic understanding of how to do economic science — i.e. they are trapped within a view of “science” that fails to produce successful explanations, and which produces unending fake science instead.

    See Friedrich Hayek’s Nobel Prize lecture “The Pretense of Science” for some sense what is at issue here.

    Posted August 7, 2009 at 12:54 am | Permalink
  2. Greg Ransom wrote:

    Sorry, make that “The Pretense of Knowledge” by F. A. Hayek, Nobel lecture.

    Posted August 7, 2009 at 12:56 am | Permalink
  3. Dan Gay wrote:

    I find it highly unlikely that a deficit of mainstream economics contributed to the financial crisis. Surely we’ve just emerged from an era in which mainstream economics dominated development theory and policy more than ever before?

    For the last 20 years Keynes was considered defunct. Hayek’s warnings about scientism were ignored – as Greg Ransom rightly points out. Hirschman became part of the decline of development economics that he so poignantly analysed. Most students never read Veblen or Marx. Minsky was resurrected too late.

    Samuelson became the poster-boy for economists, with rational choice and efficient markets the totems of the economics department. The upshot of this admiration for the mainstream was the Washington Consensus, which prescribed a mainstream formula of fiscal austerity, privatisation, current-account and capital-account liberalisation. As we now know, the Washington Consensus failed.

    Krugman recently pointed out in his LSE lecture that much of the last two decades of macroeconomics has been a waste of time. In the FT earlier this year Willem Buiter similarly addressed the failures of macroeconomics.

    Suggesting that developing countries should use mainstream economics more is like trying to put out a fire by pouring on more gasoline. It didn’t work before, and it won’t work in the future. We need to try a different approach.

    Posted August 7, 2009 at 4:18 am | Permalink
  4. Eastern cynic wrote:

    How could you believe in Efficient Markets Hypothesis and point to the “dangers of opaque instruments like derivatives, excessive mortgage lending and leverage…”. Either you believe in efficient markets and everything that comes with it, and live with financial/economic crises as facts of life. Or you believe that there is nothing inherently efficient about markets, and therefore set rules within which market can operate (and try purging the market of Madoffs).

    I think policy makers in developing countries have learned enough from past experiences to not follow “mainstream” prescriptions coming out of American universities on how to manage their economies.

    Posted August 7, 2009 at 6:36 am | Permalink
  5. mike@pvl wrote:

    I think next time a serial killer is on the loose I will call for an end to psychology. Next riot on the news will spell the doom of sociology. Next bridge collapse that happens I will blame the entire discipline of engineering.

    What on earth do I as a natural resource economist studying development in education have to do with this crisis? Yet every other day I have to listen to someone that considers my entire field defunct.

    As far as what Eastern Cynic says, I agree, we need to accept recessions and depressions as facts of life, not something that can be controlled by pulling some macroeconomic levers. Maybe if this myth were dispelled people would better prepare for the INEVITABLE shocks that come to any large scale system such as a global economy. This is like living on a fault line and complaining that no one told you there was going to be an earthquake.

    Posted August 7, 2009 at 8:35 am | Permalink
  6. Brum wrote:

    Efficient aid hypothesis

    Efficient aid hypothesis states – on the basis of mathematical proof – that all USAID’s projects fully reflect all information available at the time of their inception and are continuously adapted to new information during their implementation phase. Therefore, according to this theory, it is impossible to deliver any better aid than USAID does now. All aid failures are exclusivelly due to random factors that could not have been anticipated during project design or adjusted to during its implementation. The USAID does not bear any responsibility for these failures and cannot be criticised for them – neither by Queen of some island nor by a professor from some other island.

    Please, close down this blog. We live in a world where a theory can absolve whole profession from any social or moral responsibility for its failures. Your preposterous quest to make aid agencies more responsible and accountable is completely misguided. The efficient aid hypothesis proves beyond any reasonable doubt that we live in the best possible world and there is no scope for improvement. Aid disasters just happen and the best we can do is to predict that we cannot predicte them.

    Posted August 7, 2009 at 9:31 am | Permalink
  7. Andrea Alfieri wrote:


    it looks like you are not aiming at the post of Chief Economist at DFID….

    I love your blog!

    Posted August 7, 2009 at 10:41 am | Permalink
  8. D. Watson wrote:

    Not being able to systematically beat the stock market does not imply not being able to predict massive bubbles. The experimental evidence on experienced traders being able to predict, avoid, and deflate bubbles is suggestive in this regard.

    Posted August 7, 2009 at 1:29 pm | Permalink
  9. Max wrote:

    “The most important part of the much-maligned Efficient Markets Hypothesis (EMH) is that nobody can systematically beat the stock market. Which implies nobody can predict a market crash, because if you could, then you would obviously beat the market.”

    What rot.

    Your conclusions do not follow from your premises.

    You are indulging in “ketchup economics”

    Nobody can predict the precise timing of a crash but one can very well tell when the probability of a crash has substantially risen.

    And since you can only tell the the prob. of a crash has risen but not precisely when a crash is going to happen, you cannot make money off your knowledge.

    “…dangers of opaque instruments like derivatives, excessive mortgage lending and leverage, and the bubble in housing prices.”

    You can either claim this or believe in the EMH, but not both.

    Note that Eugene Fama, that great Defender of the Faith, did not believe that there was a housing bubble.

    Posted August 8, 2009 at 2:13 am | Permalink
  10. Greg Ransom wrote:

    Bill — In the field of non-linear dynamics, your argument would be like saying nobody can systematically predict when the growing sandpile will collapse. Which implies nobody can predict that a sandpile will inevitably collapse.

    Global economic disorder of the kind causally charted by Hayek is essentially complex phenomena — like a building sandpile, econonomists can say that the economic sandpile will collapse, and like the physicist they can’t say exactly when — and the science itself tells them why.

    Posted August 8, 2009 at 11:20 am | Permalink
  11. Greg Ransom wrote:

    Bill, just to reiterate, predicting when is different than predicting that.

    With non-linear dynamic phenomena, we can predict the that, we cannot predict the when.

    The is physics — the thing most all economists are trying to imitate. Let’s imitate a little bit better.

    Posted August 8, 2009 at 11:22 am | Permalink
  12. Mr Denmore wrote:

    The writer is mixing up his ideas.

    Yes, it is difficult, if not impossible, to profit consistently from how the market is wrong.

    But fans of the EMH have used this argument to bolster a deeply conservative political ideology which maintains that any interference with “market forces” is counter productive.

    Disquiet over this ideological rigidness is what is behind the quite reasonable criticisms of the EMH and its devotees.

    The fact is many economists and non-economists saw an unsustainable bubble developing not only in US housing but in consumer credit throughout the Anglo economies, including Britain.

    Financial intermediaries, using complex and opaque derivatives, were happy to exploit easy money by pushing people into increasingly burdensome and risky investments.

    Regulators, academically weaned on efficient markets theory and rationalist economics, suppressed their growing sense of disquiet and just “let it rip”.

    We are now all living with the consequences. The wonder is that the efficient market disciples are STILL spreading their simplistic and muddle headed message.

    Common sense is called for. That is all. It is time to recognise that “the economy” and “the markets” are not some abstract idea, but an expression of our choices as human beings. They work for us. Not the other way around.

    Posted August 10, 2009 at 8:07 pm | Permalink
  13. Ankur wrote:

    You make a good point that the EMH predicts that we cannot predict the direction of markets. However it also implies that changes to fundamentals in the markets should be “continuously compounded”, into market prices. If that is true then we should not be seeing market crashes (unless within a few months the fundamentals changed as much as the change in market prices imply). So in short, I like your point but cannot buy it as a complete answer because while it does suggest we cannot predict markets, it also seems highly likely that the EMH in it current form does not hold.

    Posted August 13, 2009 at 11:52 am | Permalink
  14. Lance wrote:

    It seems commentators are confusing the EMH with the financial journalism EMH which is “the price is right”, or that prices or asset values will never significantly decline.

    The EMH is a joint-test: market equilibrium and market efficiency. You can reject the former without rejecting the latter, and vice-versa. Market disequilibrium will often produce what we saw two years ago when the stock market began to shed value tremendously. That does not disprove market efficiency–rather, it may prove it by showing market participants were incorporating future expectations of the economy’s trajectory.

    Furthermore, the EMH does not apply to the housing market. The housing market is an illiquid market, unlike the equity market. So, it’s disingenious to say the EMH is disproved by 20%+ declines in housing prices or the existence of a valuation bubble.

    Posted August 13, 2009 at 2:18 pm | Permalink
  15. Per Kurowski wrote:

    Absolutely there should not be any finger pointing of the economists specifically.

    This crisis has nothing to do with economics and all with the lack of ordinary good common sense. Given the strong incentives of the minimum capital requirements for banks concocted by the Basel Committee for to follow the opinions of some few credit rating agencies, everyone should have known that, sooner or later, something was doomed to go wrong.

    I while an Executive Director at the World Bank (2002-2004) said so over and over again; and FT even published a letter where I, in January 2003 said that “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds.”

    Now why could we not react and stop what was being done? Because the whole regulatory debate was captured by some regulatory gnomes in Basel, who let no outsider question anything in their cozy little mutual admiration club.

    By the way, in the context of this crisis, please stop talking about a black swan or, at least, as a bare minimum, clarify that it was a black swan fabricated by the regulators.

    Posted August 13, 2009 at 9:16 pm | Permalink
  16. Eric L. Prentis, Ph.D. wrote:

    Dear William Easterly;

    Please allow me to introduce myself, Eric L. Prentis, Ph.D.

    I have an answer to your post, “The Idiot’s Guide to Answering Queen Elizabeth.”

    Please click the following link to the summary of a talk I will be giving in Houston on the Efficient Market Theory entitled, “The Credit Crisis and Its Effect on the Stock Market.”

    All the best,

    Eric L. Prentis

    Posted October 9, 2009 at 4:46 pm | Permalink
  • About Aid Watch

    The Aid Watch blog is a project of New York University's Development Research Institute (DRI). This blog is principally written by William Easterly, author of "The Elusive Quest for Growth: Economists' Adventures and Misadventures in the Tropics" and "The White Man's Burden: Why the West's Efforts to Aid the Rest Have Done So Much Ill and So Little Good," and Professor of Economics at NYU. It is co-written by Laura Freschi and by occasional guest bloggers. Our work is based on the idea that more aid will reach the poor the more people are watching aid.

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