Larry Summers's disaster scenario finally pans out

Lawrence Summers

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The role of human judgment — or lack of it — in constructing economic outcomes got a big boost from Yale University and housing expert Robert Shiller in a NYTimes column Sunday. Shiller explains that a method known as the “theory of the mind” can help put econometrics in perspective — though neither can reliably predict the future.

Shiller says that  theory of the mind is a “judgment faculty”  which is “defined by cognitive scientists as humans’ innate ability, evolved over millions of years, to judge others’ changing thinking, their understandings, their intentions, their pretenses.” It can be a powerful tool, he argues. In fact, Shiller attributes the power of that theory to the strong impression Lawrence H. Summers, now head of the president’s National Economic Council, made 20 years ago at a conference organized by Harvard Economist Marvin Feldstein on “The Risk of Economic Crisis:”

Mr. Summers told a fictional but vivid story of a big financial crisis, complete with examples of specific events and how people might react to them. Seeing it concretized as an imaginary history, and placed in the near future — in just two years, in 1991 — made it seem more real and familiar.

He said that this crisis would be preceded by an enormous stock market boom, bringing the Dow to the unimagined high of 5,400 by October 1991. (The Dow was at 2,600 on the day of the conference; 5,400 would be 13,000 today if scaled up in proportion to gross domestic product.)

Euphoria gripped the investors of his fictional universe. “The notion that recessions were a thing of the past took hold,” Mr. Summers said. He added that over a 15-year period through 1990 — a time that included the 1987 crash — investors earned an average real return of 11 percent. The popular view was that “with a reduced cyclical element, the future would be even brighter.”

via Economic View – Overlooking the Mind-Set, at Society’s Peril – NYTimes.com.

Now if only we can blend the art of judgment with the science of economics, we might be able to avert future disasters. But that would probably run counter to human instinct.

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