Thursday, September 03, 2009

How Did Economists Get it So Wrong?

The introduction and conclusion of a long article by Paul Krugman in yesterday's NYT:

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?

[skip about four pages to the conclusion]

So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.

Many economists will find these changes deeply disturbing. It will be a long time, if ever, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. To some economists that will be a reason to cling to neoclassicism, despite its utter failure to make sense of the greatest economic crisis in three generations. This seems, however, like a good time to recall the words of H. L. Mencken: “There is always an easy solution to every human problem — neat, plausible and wrong.”

When it comes to the all-too-human problem of recessions and depressions, economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly. The vision that emerges as the profession rethinks its foundations may not be all that clear; it certainly won’t be neat; but we can hope that it will have the virtue of being at least partly right.

20 comments:

Garnel Ironheart said...

Economists work based on predictable models and the assumption of rational behaviour.
Real life is unpredictable and irrational.
For example, the day before Microsoft was found guilty of anti-trust practices in 2000, we were told the Nasdaq (then at 5000) was going to go to 10000 in a couple of years. Oops.
Thus economists have as much chance of predicting what will happen tomorrow as the weatherman.

Abandoning Eden said...

Economists are wrong because they believe that we live in a market, and we don't, we live in a society. They seem to believe there is some magical force out there called the "market" that will always just turn out ok as long as we just let everyone do whatever they want. It's almost like a belief in god really..like there's some benevolent force out there making everything turn out ok. Hmm, I wonder if that's why republicans and the insane religious right seem to get along so well..they are both delusional. But really there isn't...it's just chaos and greed and individual people fucking whole groups of other people over. And of course people will exploit other people, because if you just let everyone just do whatever they please, that's what people do! And there's no magical "Market" or "god" who will stop them- that is WHY we have government. I was just reading that in the past 10 years or so the gap between the rich and poor has grown because of lowered taxes and shifted policies to the point where it is now as if each middle class family is paying an extra $7,000 a year to the upper 1%.

Holy Hyrax said...

AE

LOL

Then there is no sociology or psychology or anything else either, its all just a bunch of words.

Abandoning Eden said...

sociology essentially measures what happened in the near past..it doesn't predict the future like economists do, it just observes how people have behaved and assumes they won't change too quickly.

Holy Hyrax said...

Yes, but clearly, there is a need for economists as there always has been. You try to look at the past, see how things are flying and try your best to see where things might go. You will have to explain what you mean by economist saying people can do whatever they want though and that things will be OK. Economy DOES turn around, and get better you know.

Holy Hyrax said...

>They seem to believe there is some magical force out there called the "market" that will always just turn out ok as long as we just let everyone do whatever they want. It's almost like a belief in god really..like there's some benevolent force out there making everything turn out ok. Hmm, I wonder if that's why republicans and the insane religious right seem to get along so well..they are both delusional

A strawman if I ever did hear on. And a dumb one. When you say economy, you refer to people. Us. How are WE going to participate in the economy. Nobody believes the "market" is an independent force. It's just either saying "market" rather then laying out an elaborate explanation. Think you can devise another argument about your two most favorite groups so you can spit on them at the same time.

Holy Hyrax said...

>It's just either saying "market" rather then laying out an elaborate explanation

Meant to say:

It's just EASIER saying "market" rather then laying out an elaborate explanation

JewishGadfly said...

AE,

I don't know much about economics, but it seems "the market" is a big-picture view of the patterns that (theoretically) emerge from many details, just as evolution seems like an external force on the macro-scale but is composed of millions of tiny changes over much time.

Whether the market model is missing pieces and thus inaccurate is a different question, but I don't believe your criticism is fair.

Duck said...

I recently read a book by Jeff Rubin in which he claimed that the failure of economists is their delusion that supply always rises with demand. He blamed oil shortages for the current (and forthcoming) recessions. Seems like an interesting idea but I don't know all that much about macroeconomics. Keynesian model... has that ever really worked in practise?

Anonymous said...

A parody on AE:

"Leftists are wrong because they believe that we live in a utopia, and we don't, we live in a society. They seem to believe there is some magical force out there called "social justice" that will always turn out ok as long as we just let everything be controlled by bureaucrats. It's almost like a belief in god really..like there's some omnipotent and benevolent force in bureaucracy that would make everything turn out ok. Hmm, I wonder if that's why atheists and the insane Western-culture-hating communists have always seemed to get along so well..they are both delusional, and neither wants competition from God. But really there isn't any such omnipotent and benevolent bureaucratic force...it's just red tape and corruption and greed and little cliques of people fucking whole groups of other people over. And of course people will exploit other people, because if you just let bureaucrats control everyone, they do whatever they please; that's what people do! And there's no magical "power of the people" or "social justice" that will stop them- that is WHY we have laws on limited government and the healthy instinct to fight against too much regulation and bureaucratic control. I was just reading that in the past 100 years or so the gap in performance between the communist and capitalist economies has been proved to be outrageously evident, and that because of leftist pessimism about human nature, and their insistence on controlling the individual, wherever free markets have been stifled in favor of some utopic all-loving, all-knowing government, poverty and misery has resulted."

Really, even if someone isn't drawn to honesty, should't self-respect at least motivate them to avoid blatantly biased, ad hominem attacks?

Devil's Advocate

White Power Atheist said...

Fuck you, dirty jew!
The superior white man were tthe first atheists! AND, the first people that did not persecute atheists! Whites are the only TRUE atheists. We shall one day kill all theists and the makers of theism: niggers, Jews, chinks etc.
Heil Heil Heil

Anonymous said...

WPA,

Your comment was so poorly worded, so irrational and so primitive, that I'm tempted to think it's a prank by an intelligent person trying to sound like a wild-eyed, hung-over, bigoted illiterate.

But on the chance it's real, I'd say this: Find something to admire about yourself as an individual, instead of taking the coward's way out by wrapping yourself in the feigned glory of a group, and its pretend mission against other groups.

Also, don't you think "a superior white man" should learn to use English properly? It would be more fitting for his superiority. And it wouldn't hurt if a "superior white man" would think straight, too. Blacks and Chinese created more theism than whites? Really? Hmm, I guess all those African popes and that Chinese guy Luther really did a good job pretending they were white--as did all those Nordic and Germanic peoples worshiping their forest gods. But I guess that's how devious all these non-whites can be.

Make something of yourself. Find what interests you, and pursue it. Even if your delusions of grandeur could be fulfilled, and you killed all the "enemies" of "superior white man," do you know where you'd end up? Dead very soon just the same, like every other man and woman. Life is short; don't waste it by such nonsense.

Devil's Advocate

Comrade Kevin said...

The reason more left-brained people gravitate towards mathematics is that there is an intrinsic perfection in an equation or a formula. But human beings don't function on that premise. There's a kind of messiness that right-brained people understand that goes into any system, since markets are driven by often-illogical decisions.

Geonite said...

Most economists are clueless.

If they were smart they'd be doing something else.

JR said...

"I recently read a book by Jeff Rubin in which he claimed that the failure of economists is their delusion that supply always rises with demand."

Not an opinion held by economists.

"He blamed oil shortages for the current (and forthcoming) recessions."

Really??!!

Does he have any evidence to support to this absurd theory?

Clearly the cause of the recession is the problem in the financial markets as opposed to the real side of the economy.

e-kvetcher said...

Douglass Rushkoff has an essay online about this - here is an abstract:

We must stop perpetuating the fiction that existence itself is dictated by the immutable laws of economics. These so-called laws are, in actuality, the economic mechanisms of 13th Century monarchs. Some of us analyzing digital culture and its impact on business must reveal economics as the artificial construction it really is. Although it may be subjected to the scientific method and mathematical scrutiny, it is not a natural science; it is game theory, with a set of underlying assumptions that have little to do with anything resembling genetics, neurology, evolution, or natural systems.

Duck said...

"Not an opinion held by economists."

That supply rises to meet demand? Of course it is.

"Does he have any evidence to support to this absurd theory?"

Plenty, he wrote a whole book.

"Clearly the cause of the recession is the problem in the financial markets as opposed to the real side of the economy."

That is about the shallowest analysis of this past recession that I have ever heard.

Glenn Atias said...

Sometime about 30 years ago it started making sense to economists that we could switch over to a consumption economy. And over those 30 years, we've tripled our debt/GDP ratio. Tripled it!

After the dot com bubble burst, the Fed proceeded to blow up a housing bubble. Housing had only gone up with inflation from 1950-2000, after 2000, home values stared appreciating 2, 3, 4 times faster than inflation.

But the percentage of home equity went down from 60% to less than 40%. Home values were skyrocketing, but they were increasingly becoming bank owned!

Debt to income started diverging like never before in history. At the same time, we stopped making things. At peak manufacturing, we had almost 30 million manufacturing jobs, now we have 11 million. We stopped making things ourselves, and began this unholy dance with China, where we save at 0%, China saves at 30%, then we buy all their products and they lend us our own money back to buy yet more of their products.

We screwed up folks. And I don't mean a little screw up. Stimulus can't fix this. Bailouts just make it worse by refusing to come to reckoning with the debt, just hiding it on the books. Debt is going to have to be forgiven in wholesale fashion. Yes, by doing this many banks will fail, but it's ultimately where we have to go. Instead, we've just pushed the pain back by blowing up a new bailout bubble, which btw, has created a liquidity-driven market bubble. PEs are > 100 - the market too now is a bubble. We're still pursuing bubblenomics with vengence and calling it green shoots. And Ben Bernanke is an economic criminal of the first order.

Somehow, funny-money bubblenomics became the order of the day starting in about 1980. And it will take a generation to fix it, and no amount of stimulus or the news media screaming "green shoots" is going to circumvent the process. It will take years.

Anonymous said...

I'm tempted to think it's a prank by an intelligent person trying to sound like a wild-eyed, hung-over, bigoted illiterate.
Yep, You got it right! I'm a black teen with an iq of 137...

The Alt said...

While Paul Krugman acknowledges the flaws within current economic theory, he at the same time fails to pose a new direction for “western” economic thought. If I may be bold, maybe if American economics shopped removing economics from history they may be able to by looking at history see the relationship between economics and the history.

From what I can see economic in America started with the Great Depression. I seem to remember something called “Trust Busting” a good number of years before that.

While America speaks proudly of the American Revolution and the break from Britain it fails to acknowledge that it started out with a financial or “economic” dispute over taxes. It lead to the establishment based largely on John Locke economic theory. Locke’s words are echoed in the American Constitution.

If American economic theorists continue to view economic as unrelated and abstracted events, their theory will remain trying to tell the economy what the economy should do.