Another central banker finds a flaw

Last October, Alan Greenspan, the former head of the central bank in the U.S., sheepishly told Congress that he "found a flaw" in his theoretical framework of how the world works, going on to note that he never thought large portions of the financial industry would look past long-term solvency to achieve short-term gains.

Or something like that...

It's all here in Greenspan finds a flaw.

Well, apparently, flawed views of the world aren't unique to the western side of the Atlantic Ocean as word comes from the Telegraph this morning that Bank of England Governor Mervyn King (aka "Unswerving Mervyn") is thought to have been using flawed models of the British Economy, leading to the dramatic reversal of monetary policy over the last year that has seen short-term lending rates rise and then fall faster than London home prices.

It's all here in Flawed model 'blinded' King to credit crisis.

That's a lot of flaws and blind spots for two of the most important economies in the world.

Some excerpts:

Former members of the monetary policy committee will this week call on Mervyn King to tear up the Bank of England's complex mathematical model of the economy, as the Bank is accused of having exacerbated the recession by failing to cut interest rates fast enough when the credit crunch hit.

As King prepares to issue the Bank's latest economic forecasts this week, three former MPC members, Sushil Wadhwani, Willem Buiter and DeAnne Julius, have agreed to join an extraordinary experiment by number-crunchers at consultancy Fathom to build a rival to the Bank of England Quarterly Model (BEQM), its main forecasting model.

Interest rates have now been slashed to an unprecedented low of 1% to cushion the economy against the worsening downturn; but they were left on hold for much of last year, as MPC members fretted about the risk that rising oil prices would affect the public's "inflation expectations", which would in turn lead to surging wages. Critics say using BEQM to guide its decisions had blinded King and his colleagues to warning signs in the outside world.

Using information gleaned from publicly available documents and Bank insiders, Fathom's number-crunchers have constructed a replica of BEQM. It shows that the model actually stops working when interest rates hit zero - an increasingly pressing possibility - and fails to allow for the impact of a credit shortage on the economy.

Fathom's director, Danny Gabay, himself a former Bank economist, argues that interest rates would have been cut earlier and faster, and the recession might have been less severe, if Mervyn King and his colleagues had relied less rigidly on mathematical models, and taken more notice of what independent MPC member David Blanchflower has called "the economics of walking about".

It's funny that you don't hear too many economists criticizing other economists for not doing enough "walking about" earlier in the decade when wild-eyed lenders, borrowers, insurance companies, and hedge funds were setting the stage for the financial collapse that has occurred over the last year or so.

More and more, the current era is starting to sound like the Great Depression in that history starts after a financial bubble is fully inflated - as if how things got to that point are unimportant.

Read any history of the Great Depression (except for those written by Austrian economists) and you'll find that the accounting begins in 1929 with the stock market crash.

Never mind about the Florida housing bubble in 1925 and the credit excesses that led to the stock market bubble a few years later, for most practicing economists and virtually all central bank economists, the problems begin in 1929.

They didn't. They began much earlier in the decade then and now.