I have been reading an interesting post by Mark Thoma on how the Fed can prevent the next financial crisis, inspired by the release of minutes of Fed meetings in 2006.
Professor Thoma makes the following good points:
The Fed’s errors can be placed into two broad categories, the failure to ask the right questions before the crisis, and the failure to act quickly and aggressively enough once the crisis began. The first problem had a lot to do with economists’ undue faith in their own models and abilities – the financial meltdown problem had been solved so no need to worry about that – while the second problem is at least partly due to the way in which the public interest is represented on the Fed.
I’d like to add a third error. The Fed’s blithe confidence in their models and forecasts influenced society’s behavior. Therefore, not only were their models wrong, but their unacknowledged wrongness arguably made things worse.
In the social arena, wrong models have psychological consequences that affect the things they are modeling. Nonlinearity is built into the system, and is especially large and significant when forecasts made using the models are widely disseminated from the top.
How is belief in the Fed’s current projections affecting the projections themselves?