Four Reasons Why We Failed to Forecast the Great Recession

Our best plan is to plan for constant change and the potential for instability, and to recognize that the threats will constantly be changing in ways we cannot predict or fully understand.– Timothy Geithner

The economics profession has been appropriately criticized for its failure to forecast the large fall in U.S. house prices and the subsequent propagation first into an unprecedented financial crisis and then into the Great Recession. Here are four possible explanations of why economists got it so wrong:

1.Misunderstanding of the housing boom. Increase in house prices did not find convincing evidence of overvaluation. Thus, we downplayed the risk of a substantial fall in house prices.

2.A lack of analysis of the rapid growth of new forms of mortgage finance. Here the reliance on the assumption of efficient markets appears to have dulled our awareness of many of the risks building in financial markets in 2005-07.

3.Insufficient weight given to the powerful adverse connection between the financial system and the real economy. Despite a good understanding of the risk of a financial crisis from mid-2007 onward, we were unable to fully connect the dots to real activity until 2008.

4. Complacency affecting forecasters in the wake of the prior economic boom.

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