How did the economists get it so wrong?

Recently, Nobel Prize-winning economist Paul Krugman wrote a very interesting, in-depth article on the recent economic collapse and economists’ part in the failure. His full article (which we highly recommend) can be found here:

Krugman’s introduction presents a valuable synopsis of the problem:

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.

Krugman presents a detailed historical perspective, starting with Adam Smith’s “Wealth of Nations” in 1776, continuing to John Maynard Keynes’ masterwork “The general Theory of Employment, Interest, and Money”, Milton Friedman’s analysis of the Depression in the 1960s and 1970s, and then contemporary economists such as Michael Jensen, Robert Lucas, Edward Prescott, John Cochrane, Gregory Mankiw, Olivier Blanchard, David Romer, Larry Summers, Alan Greenspan and others. None of these economists (and the various “schools” that each represent) saw the crash coming. Typical of the reaction was Alan Greenspan, who admitted that he was in a state of “shocked disbelief”, because the “whole intellectual edifice” had collapsed.

However, as Krugman points out, it isn’t quite true that “nobody could have predicted…”. In the area of housing prices, for example, economist Robert Shiller, among others, did identify the bubble and warned of painful consequences if it were to burst. But his concerns were dismissed by the likes of Greenspan, who said that “a national severe price distortion” was “most unlikely”. Even Ben Bernanke, current Chairman of the Federal Reserve, said in 2005 that home price increases “largely reflect strong economic fundamentals”.

How did they miss the bubble? According to Krugman, a strong belief in “efficient financial markets” blinded many if not most economists to the emergence of the “biggest financial bubble in history”.

Krugman concludes:

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.

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