Why Did Economists Not Foresee the Crisis?

by Raghuram Rajan

 

Tweet

CHICAGO – At the height of the financial crisis, the Queen of England asked my friends at the London School of Economics a simple question, but one for which there is no easy answer: Why did academic economists fail to foresee the crisis?

Several responses to that query exist. One is that economists lacked models that could account for the behavior that led to the crisis. Another is that economists were blinkered by an ideology according to which a free and unfettered market could do no wrong. Finally, an answer that is gaining ground is that the system bribed economists to stay silent.

In my view, the truth lies elsewhere.

It is not true that we academics did not have useful models to explain what happened. If you believe that the crisis was caused by a shortage of liquidity, we had plenty of models analyzing liquidity shortages and their effects on financial institutions. If you believe that the blame lies with greedy bankers and unthinking investors, lulled by the promise of a government bailout, or with a market driven crazy by irrational exuberance, we had studied all this too, in great detail.

Economists even analyzed the political economy of regulation and deregulation, so we could have understood why some US politicians pushed the private sector into financing affordable housing, while others deregulated private finance. Yet, somehow, we did not bring all this understanding to bear and collectively shout our warnings.

Perhaps the reason was ideology: we were too wedded to the idea that markets are efficient, market participants are rational, and high prices are justified by economic fundamentals. But some of this criticism of “market fundamentalism” reflects a misunderstanding. The dominant “efficient markets theory” says only that markets reflect what is publicly known, and that it is hard to make money off markets consistently – something verified by the hit that most investor portfolios took in the crisis. The theory does not say that markets cannot plummet if the news is bad, or if investors become risk-averse.

Critics argue that the fundamentals were deteriorating in plain sight, and that the market (and economists) ignored it. But hindsight distorts analysis. We cannot point to a lonely Cassandra like Robert Shiller of Yale University, who regularly argued that house prices were unsustainable, as proof that the truth was ignored. There are always naysayers, and they are often wrong. There were many more economists who believed that house prices, though high, were unlikely to fall across the board.

Of course, these expectations could have been distorted by ideology – it is hard to get into the past minds of economists. But there is a better reason to be skeptical of explanations relying on ideology. As a group, neither behavioral economists, who think that market efficiency is a joke, nor progressive economists, who distrust free markets, predicted the crisis.

Could it be corruption? Some academic economists consult for banks or rating agencies, give speeches to investor conferences, serve as expert witnesses, and carry out sponsored research. It would be natural to suspect us of bias. The bias could be implicit: our worldview is shaped by what our friends in industry believe. Or it may be an explicit bias: an economist might write a report that is influenced by what a sponsor wants to hear, or give testimony that is purely mercenary.

There are enough instances of possible bias that the issue cannot be ignored. One remedy would be to ban all interaction between economists and the corporate world. But if economists were confined to the ivory tower, we might be unbiased, but we would also be ignorant of practicalities – and thus even less capable of predicting problems. One way to restore trust may be disclosure – for economists to declare a monetary interest in a particular analysis and, more generally, to explain who pays us. A number of universities are moving in this direction.

But I believe that corruption is not the main reason that the profession missed the crisis. Most economists have very little interaction with the corporate world, and these “unbiased” economists were no better at forecasting the crisis.

I would argue that three factors largely explain our collective failure: specialization, the difficulty of forecasting, and the disengagement of much of the profession from the real world.

Like medicine, economics has become highly compartmentalized – macroeconomists typically do not pay attention to what financial economists or real-estate economists study, and vice versa. Yet, to see the crisis coming would have required someone who knew about each of these areas – just as it takes a good general practitioner to recognize an exotic disease. Because the profession rewards only careful, well-supported, but necessarily narrow analysis, few economists try to span sub-fields.

Even if they did, they would shy away from forecasting. The main advantage that academic economists have over professional forecasters may be their greater awareness of established relationships between factors. What is hardest to forecast, though, are turning points – when the old relationships break down. While there may be some factors that signal turning points – a run-up in short-term leverage and asset prices, for example, often presages a bust – they are not infallible predictors of trouble to come.

The meager professional rewards for breadth, coupled with the inaccuracy and reputational risk associated with forecasting, leads to disengagement for most academics. And it may well be that academic economists have little to say about short-term economic movements, so that forecasting, with all its errors, is best left to professional forecasters.

The danger is that disengagement from short-term developments leads academic economists to ignore medium-term trends that they can address. If so, the true reason why academics missed the crisis could be far more mundane than inadequate models, ideological blindness, or corruption, and thus far more worrisome; many simply were not paying attention!

Raghuram Rajan is Professor of Finance at the Booth School of Business, University of Chicago, and author of Fault Lines: How Hidden Fractures Still Threaten the World Economy.

Malaysia's Sedition law’s overreach !

REFLECTING ON THE LAW By Prof SHAD SALEEM FARUDI

Tweet

The Sedition Act is open to many criticisms for its breadth and for its far-reaching implications on political life in the country. Some of its provisions do raise enthralling issues of constitutionality.

THE sedition charge against Sri Muda assemblyman Shuhaimi Shafiei draws our attention to the catch-all provisions of the controversial Sedition Act 1948.

Definition: Section 2 and 3(1) of the Act state that any act, speech, words or publication are seditious if they have a tendency towards any of the following:

> To bring into hatred or contempt or to excite disaffection against any Ruler or government.
Disaffection does not mean absence of affection but refers to disloyalty, enmity and hostility: PP v Param Cumarasamy [1986].

> To excite subjects to seek alteration other than by lawful means of any matter by law established.
> To bring into hatred or contempt the administration of justice in the country. In Lim Guan Eng v PP [1998], an opposition leader who complained that justice was selectively administered was convicted of this charge.

But in PP v Param the defendant’s criticism of the Pardons Board for not applying uniform standards in considering applications for mercy was held not to constitute sedition.

> To raise discontent or disaffection among the subjects. In PP v Ooi Kee Saik [1971] an opposition leader had accused the Government of gross partiality in favour of one race over another.

> To promote ill will and hostility between races or classes.

> To question the provisions dealing with language, citizenship, the special position of the Malays and natives of Sabah and Sarawak and the sovereignty of the Rulers. In Melan Abdullah v PP [1971] the editor-in-chief of Utusan Melayu had published an MP’s speech with the sub-heading “Abolish Tamil or Chinese medium schools in the country”.

Application of the law: In Param Cumarasamy it was held that intention to incite to violence, tumult or public disorder is not a necessary ingredient of the crime.

As long as the words were intentionally published and they had a tendency to cause ill will, etc, the offence is complete.

The prosecution need not prove that the act, speech or publication actually caused hostility, ill will or disaffection. It is no defence for the accused to argue that his words were, in fact, true and honest: PP v Ooi Kee Saik [1971].

Sedition can be committed either in public or in private. On the same set of facts the speaker, the printer and the publisher of a speech may all be prosecuted as in Ooi Kee Saik’s case.

Under Article 63(4) and (5) of the Federal Constitution, Members of Parliament are not exempt from the law of sedition for their parliamentary words or actions: Mark Koding v PP [1982]. 

Safeguards: Section 3(2)(a) of the Sedition Act says that a speech is not seditious if its tendency is only to show that any Ruler has been misled or mistaken in any of his measures.

Section 3(2)(b) states that a speech is not seditious if its tendency is to point out errors or defects in the implementation or administration of government policies with a view to remedying the errors or defects.

What this means is that implementation of government policies and programmes can be questioned.
But the existence of rights, privileges, powers, etc, cannot be put to debate.

Except in relation to sensitive matters, it is permissible to try to seek by lawful means the alteration of any matter established at law.

There is a defence of innocent and non-negligent dissemination in section 6(2).

No person shall be convicted if the publication was printed, sold or distributed without his consent, knowledge and without any want of due care: Melan Abdullah v PP [1971].

Under section 7, innocent receivers of seditious publications are protected if they surrender the publication as soon as the nature of the content has become known to them.

The offending passage must be read in context and as a whole: Mark Koding v PP [1982].
The presiding judge is entitled to look at the audience addressed.

Language which may have a tendency to incite youths may not have such tendency with professors or divines.

The judge is entitled to take note of the contemporary situation. In times of war, emergency or discord, a tendency to bring about one of the undesirable results may be more easily imputed than in times of peace and harmony: PP v Oh Keng Seng [1977].

Constitutionality: Though the Sedition Act has stood the test of time since 1948, it is not immune from judicial review.

Some of it’s provisions do raise enthralling issues of constitutionality.

If the Sedition Act is an Act to combat subversion, then it suffers from a number of manifest defects.
> Every law made under Article 149 must contain the recital prescribed in Article 149(1).

The Sedition Act contains no such recital. Absence of a recital amounts to a violation of a mandatory procedural requirement.

The alternative approach could be that the absence of a mandatory recital relegates the Act to the status of an ordinary law under Article 10 that is bereft of the special scope of Article 149.

> Under Article 149(1) subvesive action must be taken or threatened by “any substantial body of persons”.
Actions of lone dissidents are not within Article 149’s contemplation. Yet the Sedition Act criminalises individual acts of dissent or disaffection.

> In section 2 of the Act, the definition of “publication” includes all written or printed matters and any visible representation.

This means that even a purely private, non-printed, non-circulated matter that is left in a person’s drawer (but discovered by the police in a search under section 8(1) can be regarded as a “publication”.

This means that the Act goes for an overkill. Its prohibitions show no necessary nexus or connection with the action or threat of a substantial body of persons to do the prohibited things in Article 149(1)(a) to (f).

> In sections 2 & 3 of the Act, sedition is not to be judged by actual facts or by criminal intention but by a speculative and subjective “tendency”.

However, in Article 149(1), “tendency” alone is not enough. The alleged action must be of a nature so as “to cause”, “to excite”, “to promote”, “to procure” or be prejudicial to public order, etc.

If the Sedition Act is a law under Article 10(2) and 10(4), then its restrictions must fall within the borders of the explicitly enumerated grounds in these Articles.

It is arguable that many of the provisions of the Act, e.g. section 3(1)(a) on exciting disaffection against any government go far beyond the permissible limits.

In PP v Pung Chen Choon [1994] it was held that where a law authorises restrictions in language wide enough to cover restrictions both within and outside the permissible limits, the law cannot be upheld.

In the same case it was provided that in order to determine whether a particular piece of legislation falls within the orbit of permitted restrictions, the objects of the law must be sufficiently connected to the eight restrictions enumerated in Article 10(2)(a).

The connection must be real and proximate, not far-fetched or problematical.

There is emerging jurisprudence in the case of Shamim Reza that, as in India, parliamentary restrictions on fundamental rights must be “reasonable” in order to be valid.

The concept of sedition in Malaysia is much broader than in the UK, Ireland, India and Australia.

On ideal democratic standards, the law is open to many criticisms for its breadth and for its far-reaching implications on political life in the country.

For this reason it is ripe for review. Whether the technique for law reform will be legislative or judicial remains to be seen.

> Shad Saleem Faruqi is Emeritus Professor of Law at UiTM and Visiting Professor at USM

Home, not so sweet home

Ceritalah By Karim Raslan

Tweet

Many students abroad are thinking of staying back to work in London, New York or other cities, with their parents agreeing — and some even encouraging their kids not to return.

LAST month, just before I went to Davos, I gave a talk at Cambridge University. I first went there in 1982, some 28 years ago, and this visit made me feel very old. I suddenly realised that for the current students, I was like a relic.

Still, Cambridge — even after a gap of almost three decades — remains a lovely place. The town has barely changed, with students on bicycles everywhere. Indeed, the centre has been almost entirely pedestrianised, and ancient College buildings scrubbed clean.

The morning after the talk I found myself walking along King’s Parade — the town’s most prominent thoroughfare and through my old college, St Johns. It was a beautiful wintry morning, misty and with a light frost on the ground.

To my surprise, the colleges now charge tourists an entrance fee. However, with all the bravado of a former student, I just marched through the entrance, striding from one pebbled courtyard to another, past buildings that had seen the test of time.

It’s hard to express the sense of time passing. Here I was 28 years older, striding past buildings and a landscape (the trees and the river Cam) that has remained seemingly unchanged. I couldn’t help but wonder how I’d spent all the years.

I was in Cambridge to give a talk on Indonesia. It was also a thinly veiled opportunity for me to recruit people for my consulting practice, and indeed I was to do the same with students from Kings’ College, London, and from a dynamic Malaysian students group called UKEC.

My small business depends on drawing in bright, curious and hard-working young people who are willing to challenge assumptions, hit the ground, talk to businessmen, politicians, regulators and media practitioners while also ploughing through thousands of newspaper articles and reports.

In short, it’s not easy work; and the boss is very, very demanding.

I used to worry about recruiting, but nowadays, I’ve begun to realise that my regional focus — advising corporates, individuals and funds across South-East Asia — is an exciting proposition for young people hankering after experience and exposure.

Indeed, being in Indonesia, the Philippines and Thailand as well as Singapore has given me an enormous advantage in terms of recruitment in that, I’m able to offer the young people a real taste of doing business both inside and outside Malaysia.

Back when I was a young student, I couldn’t wait to return home to Malaysia. My enthusiasm to go home was infectious. I’d sit up all night with friends and talk about what I wanted to do with my country.

To be frank (and this is one of life’s little lessons), I’ve forgotten and/or failed to achieve the things I had set out to do. Instead, I’ve gone on and done other things.

However, nowadays when I meet with students, I sense a growing reluctance to return home. Many of the students are thinking of working elsewhere and making plans to get jobs in London, New York or other cities.

Indeed, when I check with friends whose kids are studying abroad, virtually all of them have agreed to let their kids stay on and work. Some have actually encouraged their kids not to return.

In the 1980s, this was a non-Malay phenomenon. In the 2010s, it’s a Malaysian trend as Malays have also joined the ranks of those who have elected to stay abroad.

Many of the students who choose not to return are sons and daughters of the middle class. Maybe there’s nothing wrong with us losing these young people? Maybe they’re not loyal enough? Maybe their semangat ke-Malaysia-an is too weak?

However, having chatted with the students, I’ve come to see that they love their home country as much as anyone else. But, when presented with alternative options, they chose not to return.

Isn’t this something we should be concerned about? Shouldn’t we be trying to make Malaysia more attractive for our bright, well-educated, young people? Shouldn’t we address the issues they face?

Top of the list is salary. Malaysian wages are caught in a deflationary trap — especially when compared with what’s on offer in the UK, the US or even Singapore.

Next up is a sense of frustration with the unnecessarily bureaucratic and unresponsive government machinery as well as the controls on personal freedom.

The breakdown between public and private morality also causes anguish for many, especially those still experimenting with life’s endless possibilities.

Young people don’t want to demonstrate all the time — they just want to know there’s a real and effective legal and political system that offers them a choice of leaders.

Malaysia won’t lure back the many tens of thousands of young people till we address these problems.

Despite all these hurdles, I’ve found that bright, ambitious young men and women will jump at a chance to work — even if the salaries aren’t great — so long as they’re given exposure and experience across South-East Asia, its 11 countries and 500 million people.

In short, we have to tell our young people that Kuala Lumpur, indeed Malaysia, can be a platform to explore the whole of Asean. Then they’ll come, and in their thousands.