Why Did Economists Fail to Predict the Crisis?

Last Updated May 14, 2009 7:34 AM EDT

  • The Find: Believe it or not, economists "failed to account for the critical roles that banks and other financial institutions play in the economy" and rejected common sense truths that did not fit their mathematical models, argue several business professors.
  • The Source: An fascinating article from Knowledge@Wharton.
The Takeaway: Americans are known to be occasionally suspicious of experts and intellectuals, and sometimes, just sometimes, there appears to be a grain of sense in the view that the ivory tower is not the best vantage point for surveying the reality of life on the ground â€" at least when you read articles like the current piece on why economists failed to foresee the financial crisis in Knowledge@Wharton. According to a series of professors (who perhaps are not the best placed critics to comment on the limitations of academics), economists failed to predict the crisis, in essence, because they refused to acknowledge untidy realities that would mess with their elegant mathematical models. "It's not just that they missed it, they positively denied that it would happen," asserts Wharton finance professor Franklin Allen. He explains:
Over the past 30 years or so, economics has been dominated by an 'academic orthodoxy' which says economic cycles are driven by players in the 'real economy' -- producers and consumers of goods and services -- while banks and other financial institutions have been assigned little importance.
So to summarize: "They simply didn't believe the banks were important." Doh! What other realities did economists ignore to prop up their mathematical models? Common sense truths like the unlikeliness of a perpetual rise in home prices and the irrationality of real people's decisions about money, says Wharton management professor Sidney G. Winter.
These may sound like head-slapping, obvious mistakes now, but, as they say, hindsight is always 20/20, and it wasn't like your average Joe (or Jane) saw this coming either. For a much more detailed take on just how academic economists failed to make the call, check out the informative and in-depth article.

The Question: How can economists make sure they stay more grounded in the real world in the future?

(Image of Doh! moment by striatic, CC 2.0)

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    Jessica lives in London where she works as a freelance writer with interests in green business and tech, management, and marketing.