Will economists be able to see the next financial crisis coming?
That’s a whopper of a question, so how about starting with this one instead: why do we get traffic jams?
Sometimes they’re caused by an accident or road works, but often congestion just builds up for no particular reason and is impossible to foresee.
You may wonder what this has to do with financial crises, but according to Richard Bookstaber, this question gets right to the heart of them and the problems of economics.
Richard Bookstaber is the author of The End of Theory, fellow at the University of California, oversaw risk management at Morgan Stanley, Salomon brothers, two hedge funds and advised on risk at the US treasury.
If you think of people as predictable and rational rather than the imperfect individuals that we are, then traffic jams would be a physical impossibility. Everyone’s behaviour would be orderly and predictable and traffic would never build up.
This is exactly what economics does.
Economics like to treat people like ‘physical particles’ that obey mathematical rules and models.
It is for this reason that traditional economics cannot predict financial crises – the financial equivalent of traffic jams – says Rick Bookstaber, this week’s guest on the Big Money Questions show.
He argues that you can’t model a crisis using ‘conventional tools’, nor assume, as economists so often do that the future looks like the past. ‘A crisis doesn’t look like the past – not even the same as previous crises’ he says.
There is a solution, though, he says.
‘Part of the solution is to have a system or method that doesn’t say ‘here are the axioms, here is the model, this is the way people act, now let’s run with it’. It’s to have a model that can mould itself, change itself as I see the world changing, building a story that develops with the way the crisis is evolving as opposed to saying ‘hey, I have it all solved’ – because you can’t have it all solved it’s going to change you have to follow along the path with it.’
That means factoring in what you know about what’s happening in the lead up to the traffic jam and as it happens into your view of how it is likely to play out.
Get ahead of the economists and watch Rick’s full interview in the Big Money Questions show.
Some links in this article may be affiliate links. If you click on them we may earn a small commission. That helps us fund This Is Money, and keep it free to use. We do not write articles to promote products. We do not allow any commercial relationship to affect our editorial independence.
