Thursday, September 17, 2009

Paul Krugman (NY Times Magazine): How Did Economists Get It So Wrong?

How Did Economists Get It So Wrong?

It’s hard to believe now, but not long ago economists were congratulating themselves over the success of their field. Those successes — or so they believed — were both theoretical and practical, leading to a golden era for the profession. On the theoretical side, they thought that they had resolved their internal disputes. Thus, in a 2008 paper titled “The State of Macro” (that is, macroeconomics, the study of big-picture issues like recessions), Olivier Blanchard of M.I.T., now the chief economist at the International Monetary Fund, declared that “the state of macro is good.” The battles of yesteryear, he said, were over, and there had been a “broad convergence of vision.” And in the real world, economists believed they had things under control: the “central problem of depression-prevention has been solved,” declared Robert Lucas of the University of Chicago in his 2003 presidential address to the American Economic Association. In 2004, Ben Bernanke, a former Princeton professor who is now the chairman of the Federal Reserve Board, celebrated the Great Moderation in economic performance over the previous two decades, which he attributed in part to improved economic policy making.

Last year, everything came apart.

Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy. During the golden years, financial economists came to believe that markets were inherently stable — indeed, that stocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year. Meanwhile, macroeconomists were divided in their views. But the main division was between those who insisted that free-market economies never go astray and those who believed that economies may stray now and then but that any major deviations from the path of prosperity could and would be corrected by the all-powerful Fed. Neither side was prepared to cope with an economy that went off the rails despite the Fed’s best efforts.

And in the wake of the crisis, the fault lines in the economics profession have yawned wider than ever. Lucas says the Obama administration’s stimulus plans are “schlock economics,” and his Chicago colleague John Cochrane says they’re based on discredited “fairy tales.” In response, Brad DeLong of the University of California, Berkeley, writes of the “intellectual collapse” of the Chicago School, and I myself have written that comments from Chicago economists are the product of a Dark Age of macroeconomics in which hard-won knowledge has been forgotten.

What happened to the economics profession? And where does it go from here?

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.

It’s much harder to say where the economics profession goes from here. But what’s almost certain is that economists will have to learn to live with messiness. That is, they will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic “theory of everything” is a long way off. In practical terms, this will translate into more cautious policy advice — and a reduced willingness to dismantle economic safeguards in the faith that markets will solve all problems.

II. FROM SMITH TO KEYNES AND BACK

The birth of economics as a discipline is usually credited to Adam Smith, who published “The Wealth of Nations” in 1776. Over the next 160 years an extensive body of economic theory was developed, whose central message was: Trust the market. Yes, economists admitted that there were cases in which markets might fail, of which the most important was the case of “externalities” — costs that people impose on others without paying the price, like traffic congestion or pollution. But the basic presumption of “neoclassical” economics (named after the late-19th-century theorists who elaborated on the concepts of their “classical” predecessors) was that we should have faith in the market system.

This faith was, however, shattered by the Great Depression. Actually, even in the face of total collapse some economists insisted that whatever happens in a market economy must be right: “Depressions are not simply evils,” declared Joseph Schumpeter in 1934 — 1934! They are, he added, “forms of something which has to be done.” But many, and eventually most, economists turned to the insights of John Maynard Keynes for both an explanation of what had happened and a solution to future depressions.

Keynes did not, despite what you may have heard, want the government to run the economy. He described his analysis in his 1936 masterwork, “The General Theory of Employment, Interest and Money,” as “moderately conservative in its implications.” He wanted to fix capitalism, not replace it. But he did challenge the notion that free-market economies can function without a minder, expressing particular contempt for financial markets, which he viewed as being dominated by short-term speculation with little regard for fundamentals. And he called for active government intervention — printing more money and, if necessary, spending heavily on public works — to fight unemployment during slumps.

continue (its quite a long article)

John Quiggin: The Macro Wars

The macro wars
September 17th, 2009

Paul Krugman’s piece on “Why did economists get it so wrong” has attracted a vitriolic response from John Cochrane, reproduced here. Krugman’s piece was strongly worded, but the reply ups the ante, and I expect further escalation. Economics conferences in the next few years are going to be interesting events.

Given that, as Krugman himself notes, disagreements between economists were notably mild until the crisis erupted, what is going on here?

I’m visiting Berkely at present and just had a chat with Brad DeLong. These are some of the thoughts I had about the great macroeconomics wars as a result.

One important element that can’t be ignored is the effect political partisanship, which is much more bitter in the US now than in most other places. It’s not so much Republicans vs Democrats as Republicans vs anti-Republicans. Krugman has been a leading figure in rejecting the idea that the Republican party represents a serious viewpoint that should be accorded respect, even in disagreement. Not surprisingly, the members of the intellectual class still associated with the Republican Party (relatively few, these days, but still dominant in Chicago) intensely dislike Krugman’s writing for the NYT.

But more important, I think, is the hole in the intellectual landscape opened up by the crisis. As regards macroeconomics, the pre-crisis near-consensus described by Krugman included a lot of “freshwater” macroeconomists whose intellectual roots go back to the New Classical/Real Business Cycle literature of the late 1970. This literature initially suggested that there was no possible role for monetary or fiscal policy unless people had mistaken expectations and drew the implication that a sufficiently credible and determined government could eliminate inflation without any serious cost in terms of output and employment, a theory tested to destruction by the Thatcher government.

Given the empirical difficulties encountered by strong forms of these views, most of the freshwater economists were prepared to make some concessions. As regards monetary policy, they were willing to accept some use of interest rates to target inflation, while arguing against “fine tuning” designed to stabilise the economy – during the Great Moderation it was easy enough to conclude that macro instability was a problem of the past, a claim made explicitly by Robert Lucas.

Similarly, it was easy enough to accept the implication that, in certain extreme circumstances like those of the Great Depression, the standard tools of monetary policy might prove ineffective necessitating direct use of fiscal policy to expand the money supply. In the absence of any perceived risk of a Depression, it was easy enough to make this concession while arguing against any use of active fiscal policy.

In the wake of the crisis, this position was untenable. If you supported fiscal policy at all, it was clear that a massive stimulus was needed. In fact, the arguments of Barro and others that Keynesians had overestimated the multiplier effects of fiscal stimulus implied that the required stimulus was even larger than Keynesian estimates would suggest.

Moreover, there is, as Brad DeLong and others have pointed out, no coherent position under which fiscal policy is totally ineffective while monetary policy is at least partly effective. And the only plausible conditions under which policy is totally ineffective is if the macroeconomy is always in (or close to) equilibrium. So, it’s essentially impossible to believe in recessions and unconditionally oppose fiscal policy.[1]

So we see Cochrane forced all the way back to Say’s Law, the claim that it is logically impossible for (planned) supply to exceed (planned) demand, since willingness to supply, say, labour implies willingness to demand goods. Cochrane accuses Krugman of wanting to scrap the macroeconomics of the last forty years[2] but then makes it clear enough that he wants to dump Keynes and everything that has been written since.

Arguments about Say’s Law are unlikely to be resolved by logical disputation. The only way to address them is to look at the historical record of the economy over the last couple of centuries. If you see stability, interrupted only by the occasional ill effects of government policies, you’ll accept Say’s Law. If you see regular crises, except for a few exceptional periods when macroeconomic stabilization policies have appeared to work, you’ll reject it.

fn1. Except for those who can always find some government program or another to blame, even for a case as clear cut as the 1890s Depression in Australia.

fn2. This charge is broadly correct, but I think the correct answer is the one anticipated by Cochrane. Economics did indeed take a wrong turn in the 1970s, responding to the breakdown of (one version of) Keynesianism. We need to find a new and better response, and much of the work of the past 40 years will have to be be discarded or reinterpreted as a result.