Noah Smith vs. Steven Keen: Who Predicted the Crisis?

     There are now a number of economists who believe we may be back to much greener pastures in the economy in time for next year's elections.

      http://diaryofarepublicanhater.blogspot.com/2013/06/gop-strategy-for-2014.html

      "Times have changed since 2010. Barring a fresh crisis — and there are certainly a few that could arise — many economists expect growth to return to a fairly healthy level by next year as house prices and the stock market continue to rise and the jobless rate falls closer to its historic average of 5.8 percent."

      Read more: http://www.politico.com/story/2013/05/2014-election-economy-92053.html#ixzz2UydLdaUZ

      This if true, is very good news for the country; it is also good news for the Democrats-which in itself is further good news for the country. 

       However, it's also when the legacy of the Lesser Depression-or Great Recession-starts to be assessed. Whether we're there or not, this process of assessment is on its way. Sumner has certainly been working hard to be in a position to declare victory when this ends. He will have "disproven" the fiscal multiplier due to the claim of monetary offset. 

      http://diaryofarepublicanhater.blogspot.com/2013/06/sumner-and-krugman-frenemies-forever.html

      Noah Smith has a very interesting piece about one issue that will doubtless be discussed and debated within the econ world for many years: who predicted the crisis? As he rightly points out, it's not a wholly unambiguous question to ask Who predicted the cirsis as it depends what part of it you have in mind. There was the drop in housing prices of 2006-2007, the collapse of the financial system in late 2008, and the long recession we've been in since-which technically started in 2007. 

     In this sense, it can be argued that the market predicted the crisis as the equity market started plunging in July 2007 after the conference call of Angelo Mozillo-President of Countrywide Financial. The market fell 200 points the next day after he said the housing market might not come back until 2009. This prediction would prove to be way too optimistic but at the time it totally spooked the market. The official recession would be from late 2007 to June 2009 so the market was pretty close in predicting it. 

    As Smith argues there are all kinds of shades of "predictions." You can predict the duration and there's the question of how much conviction you made your prediction with. I would note that on this score Reinhart and Rogoff did successfully predict one thing: the duration of the crisis. Their book is usually misunderstood. Everyone tihnks the title It's Different This Time is an admonishment that of course it's not different this time it's never different and thinking so is wishful thinking but that's not the point. It actually was different this time: the economy really had faced a once in a century event-like the 30s Their point that financial crises really are different was dead on. However, they later discredited themselves by becoming boosters for austerity. 

    In this post, however, Smith chooses to focus on Steve Keen. This is big. I read it as the Neoclassical School hedging their bets to make sure the wrong lessons aren't learnt from the crisis. Smith was chosen to do this as he has impeccable liberal-Keynesain credentials. 

    "Steve Keen, formerly a professor at the University of Western Sydney, is known for claiming moreloudly and confidently than just about anyone else on the planet that he "predicted the global financial crisis". According to Keen, this should be a reason to believe his extensive critiques of neoclassical (i.e. mainstream) economics, and his suggested alternative paradigm, known as "Post-Keynesianism".

    "So in what way did Keen "predict the crisis"?

    "Searching the internet, I can find no record of an ex-ante prediction by Keen of a large-scale U.S. housing bubble. He did, however, predict an Australian housing bubble, in 2007 after the U.S. housing bubble had already begun to pop. That prediction has so far yet to materialize; Australian housing prices have not collapsed yet. As a result of this incorrect prediction, Keen lost a high-profile bet."

     "Did Keen predict the collapse of the U.S. finance industry (the Lehman shock and subsequent bailouts)? Not that I can find. Nor did he warn of the risk of such an industry collapse, as far as I can find."

     "How about the recession and stagnation? Here, Keen makes his strongest claim to have made an ex ante prediction. His argument is laid out in this paper. (Warning: as others have noted, Keen's papers are nearly unreadable.)"

     http://noahpinionblog.blogspot.com/2013/05/what-does-it-mean-to-have-predicted.html

      Ouch! This tells you the Establishment wants to discredit him. Incidentally, this doesn't mean that Smith is totally wrong. I'm just giving the larger sociological context. It's been observed that the econ school is about science and knowledge, however, at the same time it's also a society made up of Establishment-Neoclassical-economists. They act like any society upon being attacked. 

    "Much of the paper covers the history of macroeconomics as Keen sees it. Later, on page 10, we get to the part where he explains how he "predicted the crisis". Keen presents a macroeconomic model; actually, a class of macroeconomic models. Each of the models is a system of deterministic Ordinary Differential Equations describing the behavior of macroeconomic aggregates. He claims that this sort of model would allow one to realize that a crisis of the type we observed could potentially occur."

    "Notice, therefore, that this is not a prediction of timing. It is a prediction of the particular characteristics of a recession. And as to whether or not it is intended to be a prediction of the severity or duration of the recession...that's not clear. Keen isn't saying when a recession would happen, he's saying that his model shows what it would look like."

     A large part of Keen's argument amounts to the claim that the conventional Neoclassical models couldn't have predicted the crisis as their models don't even recognize a crisis the magnitude of what we had is possible. 

    "I n any case, it is clearly apparent that nowhere in this paper - or in any other paper that I can find - does Keen present a model whose output bears even a passing resemblance to the crisis we experienced in the late 2000s. (As an aside, note that many models, including a simple neoclassical Ramsey model, have equilibria in which the economy collapses completely. Building such a model is very very easy. But complete economic collapses - total and permanent cessations of economic activity - haven't yet been seen in the real world...ever.)"

     "Therefore, we can conclude that there is no Steve Keen model that predicted the recession and long stagnation that we've experienced. And in fact, there does not seem to be any "Post-Keynesian model" whose features closely resemble the financial crises and recessions that we see in the real world."

 

     "So did Steve Keen himself warn in the early or mid 2000s of the impending possibility of an economic collapse? He claims that he did warn of an "impending global recession" in 2005 (see also here). I cannot find any actual writings by Keen from 2005, but I will take him at his word, since if he had made this up, I'm sure that his fellow Aussies would quickly tar and feather him for it. (If you have links to the 2005 prediction, please post them in the comments section.)"

     "So Steve Keen presumably did warn in 2005 that a global recession was coming. This means that, counting his prediction of an imminent Australian crash, he has a 50% success rate. Remember that, according to Bayes' Theorem, the predictions of someone with an unconditional 50% success rate (i.e., coin flips) convey no information."

     "But is that his true success rate? After all, how many earlier predictions of imminent global recession has Keen made, that did not materialize? According to this website, Keen was predicting an imminent global recession as early as 1995. It was 12 or 13 years before his prediction came true; this long time lag makes the prediction a bit less impressive, since someone who in 1933 predicted a global recession - which did come, 80 years later - would nevertheless now be seen as having been "wrong". Now, 12 years is better than 80 years, of course."

      That's one way to look at it. If I've been predicting a crisis for 20 years and it finally happens is this impressive as I was wrong for 20 years? Actually, Minsky had straited making predictions along these lines after the 1966 financial crisis. If you warn someone that their diet-I'm not one to tak about diets-is going to lead them to get cancer for 8 years and it finally happens what does this show? I suspect this is how Keen looks at it. 

     "Anyway, so we see that Steve Keen's prediction of the global financial crisis was considerably less impressive than his bold claims would have us believe. He does not have a model that can predict bubbles, financial collapses, or recessions. His personal warnings of doom often don't seem to materialize for over a decade...if they materialize at all. If you trust Steve Keen as an economist or as a personal prognosticator based on his 2005 warnings of imminent global recession, you may be falling victim to the common behavioral phenomenon of overconfidence. (Not that I expect this fact to give pause to many of his...um...ardent followers. Remember that pundits get more fans by displaying self-confidence than by being right!)"

     "Of course, all this is not to say that Keen should receive zero plaudits, respect, or commendation for his 2005 warning - or, for that matter, for his 1995 and 2007 warnings. There are plenty of people out there who said that finance has nothing to do with recessions. There are plenty of people out there - including some very prominent mainstream economists - who said that big recessions couldn't happen anymore. However right Keen did or didn't get it, those people got things far less right."

     "Anyway, a similar exercise can be applied to any other economist, model, or pundit whom you think may have "predicted the crisis". You will obtain varying results, though my bet is that few will be as spectacular as you might hope."

     "In conclusion: Predictions are hard, especially about the future. Sometimes people get things right because they understand how the world works, and sometimes they get things right by luck. The idea of a brilliant Cassandra-like sage, shouting in the wilderness while everyone ignores his or her trenchant warnings, is occasionally true, but not as much as we would like to think."

     I'm a little skeptical of predictions myself, but I still think Keen gets a lot right. You don't need to predict something to make a case for a model. Keen's target seems to be those pundits that Smith himself eludes to. In 2003 the establishment itself was celebrating the end of the business cycle. 

    Interesting stuff. A lot to chew on. As more occurs to me about this I'll share it with you. What really matters is Keen's critique of the Neoclassical model. It may be that he focuses too much on predictions but what about his claims about the shape of the supply and demand curves? This is where the far-reaching consequence's are to be found.