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We recently had a class assignment – Analyze Alan Greenspan’s decision to keep the interest low for a long time and raising it very slowly. Many say this policy along with a lackluster regulatory policy led to the current housing led credit crisis.

It was a very interesting exercise and though I wasn’t able to reach the “right” conclusion, I felt that the he did indeed keep the interests low for a longer time than needed. This conclusion came based on my analysis of the GDP gap as perceived (based on Taylor rule and then data) by Greenspan vs. my own estimate of the GDP gap. The increasing natural rate of unemployment also provided some direction towards my conclusion. I cannot exactly share my data, charts, and analysis here because … it was an assignment that may be given next year also and I don’t yet know my grades on the assignment .

What I want to discuss here is one of the statements made during the class –  The economists have not yet build a model that can capture the true relationship between Alan Greenspan’s decisions and the housing crisis. My question is – Can such a model be built? Can it be predictive in nature, and not just retrospective? Lets start by asking a more fundamental question…

Can consumer behavior be modeled? To some extent, yes. Marketers tend to model behaviors all the time in order to sell consumers exactly what they want, and do not want, in the most (un)appropriate times. Numerati (Stephen Baker’s book) talks about various such models and how it is revolutionizing the industry. But this behavior is always predicted based on certain other behavioral patterns and not on demographics, access to cash, and spending power (Note that such models also do exist but may not be the right way to segment consumers).

How can you predict what a consumer will do when he is given easy access to large amount of cash? We look for patterns. We look around ourselves and see what do people do in such cases. When a person gets a great job that comes with large salary incentives, what does he purchase first? When a new generation enters the workforce, what do parent recommend them they do with the money earned? When somebody wins a lottery, what is the one thing he invests in? Does ‘buying a house’ answer all the questions above to some extent? Probably yes.

How can we test this hypothesis? Can this pattern be quantified in an equation? Can it lead to building a model that can actually prove that Greenspan is the root cause of this disaster? Thoughts?