Didn’t See It Coming

In response to the post, “Markets and Government,” a student asked, ”I would like to know if economist knew that we were going to suffer from the financial crisis? If so, why didn't they do anything about it? I find it kind of interesting that nothing was done to keep us out of the financial situation we are in now....or was it just too late?”

The answer to the first question is a little embarrassing, few economists saw the financial crisis coming.  Although not a satisfying answer, the main reason so few recognized the danger is that the vast majority of economists have expertise and interests outside of the housing market and finance.  The answer is not satisfying for a second reason, few financial economists saw it coming either and their warnings were largely ignored. Raghuram Rajan, who I quoted in “Markets and Government,” was one economist who saw the writing on the wall.  Others included Nouriel Roubini, and Nassim Taleb.  The financial crisis was the confluence of many problems, most of which were seen and understood.  Government officials carefully created a system of regulation to deal with these problems and economists added a great deal of insight into these regulations.  This implies that my student’s assumption in framing the second question is probably wrong, it wasn’t that the government did nothing; it was that the steps it took were ineffectual or inadequate.  As Seabright wrote in Foreign Policy,  “The Imaginot Line,”

There are important lessons to be learned from the [financial] crisis. But we'll learn them better if we realize that the intellectual and political architects of the system that failed us were not naive at all, but immensely clever and subtle; it was their cleverness and subtlety that undid them. And that is bad news for all of us, for naivete can give way to learning, but cleverness has no obvious higher state.

Seabright explains the regulatory philosophy that guided the government and why it failed.  His article is a good place to start, but the issue of what caused the financial crash is so enormous that economists will debate its root causes for a century.