“Of course, there were exceptions to these trends: a few economists challenged the assumption of rational behavior, questioned the belief that financial markets can be trusted and pointed to the long history of financial crises that had devastating economic consequences. But they were swimming against the tide, unable to make much headway against a pervasive and, in retrospect, foolish complacency.”

Paul Krugman, New York Times Magazine, September 6, 2009

Amen.

In two sentences, Professor Paul Krugman, Nobel Laureate in Economics for 2008, has summed up the failure of an entire era in economic thought, practice and policy discussion.

And yet, there is something odd about the role of this short paragraph in an essay of over 6,500 words. It’s a throwaway. It leads nowhere. Apart from one other half-sentence, and three passing mentions, it’s the only discussion of those economists who got it right. Only one is mentioned by name. Their work is not cited. Despite having been right on the greatest economic questions of a generation, they are unpersons in his tale.

Forgive me for pointing out that on this topic I’m Roald Amundsen to Paul’s Robert Falcon Scott. I got there first. My complaint, entitled “How The Economists Got It Wrong,” ran in The American Prospect NINE years ago. I would not now repeat the unkind things I said then about Paul, but the conclusion is still right:

“Leading active members of today's economics profession, the neoclassical generation now in its forties and fifties, have formed themselves into a kind of Politburo for correct economic thinking. As a general rule ‑ as one might generally expect from a gentleman's club ‑ this has placed them on the wrong side of every important policy issue, and not just recently but for decades. They predict disaster where none occurs. They deny the possibility of events that then happen. ... They oppose the most basic, decent and sensible reforms, while offering placebos instead. They are always surprised when something untoward (like a recession) actually occurs. And when finally they sense that some position cannot be sustained, they do not reexamine their ideas. They do not consider the possibility of a flaw in logic or theory. Rather, they simply change the subject. No one loses face, in this club, for having been wrong.... And still less is anyone from the outside invited in.”

As Paul notes, some economists did get it right. This was also true a decade back, when the immediate problems were the Asian and Russian crises, and inequality, and the technology bubble. There’s nothing much new about this problem. Paul knows this. Yet he doesn’t push for the rehabilitation of those who were right. There is no movement here, to break open the field, to diversify and to reconstruct, to change the personnel and the hierarchy of departments, journals, textbooks and reputations. And until that happens, what is called the “mainstream” in macroeconomics will continue to run dry.

The question of who got it right, and why, deserves more attention, and I plan to take it up in another place.

Meanwhile, others have noted below that in Washington the academic macro-economists carry no weight. How could they? They have had nothing to say to the policy community for decades. Try to persuade a Member of Congress, of either party, that recessions are self-correcting, that stimulus is offset by saving to pay off the eventual increase in taxes (and therefore useless), or that the Federal Reserve should ignore unemployment. It can’t be done. Yet such rubbish has been a staple of textbook economics, and academic macro, for decades.

(On this point, consider the wonderfully-titled paper by Robert Solow, delivered to the 60th birthday conference for Joe Stiglitz at Columbia in October, 2003. It was called, “Dumb and Dumber in Macroeconomics.” Sitting next to my distinguished Yale classmate Ernesto Zedillo, as we listened to it, I remarked that I always hoped that if one could only close one’s eyes for thirty years, this would all go away. He said, “Yes, it was a very good time to go into public service.”)

Still, on certain critical issues the “impressive-looking” and “gussied-up” cult of free markets did dominate policy. Where the cult served the lobby culture, it tended to win out. Right up to the crisis, this was true of attitudes toward financial deregulation and privatization, toward the repeal of Glass-Steagall, and in the dismissive approach taken to those (like the FBI!) who warned about massive mortgage fraud and the impending housing bust. It was true of those who thought the Federal Reserve could wave its wands and guarantee that the “Great Moderation” would long continue. It is true -- today -- of the reflexive deficit-worriers who are well-represented among my colleagues below.

Even the mostly-sensible policy economists have not yet fully rethought their assumptions -- even now.

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1. I agree with Krugman that academic macroeconomics went haywire some years ago. Many economists got out of academic macroeconomics because there seemed to be no way to fight the emerging and mistaken consensus. One place that fought the good fight for sensible macroeconomics was Brookings, where the Brookings Papers on Economic Activity remained true to sensible macroeconomics at the price of losing credibility with the academic profession.
2. What is less clear is whether actual macroeconomic policymaking in Washington was greatly influenced by the papers in the economics journals. My experience in the Clinton Administration in the 1990s, including the interactions with the Federal Reserve, suggested that actual stabilization policy was governed by a pragmatic view of the economy that combined the important lesson from Keynes about the potential instability of the economy together with what we learned subsequently in the postwar period, including the substantial power of monetary policy—something that Keynes downplayed.
3. The pragmatic consensus among policymakers failed miserably in this crisis because the postwar period lulled us into a false sense of security. We believed that adjusting short term interest rates and using occasional fiscal policy were all that was needed to avoid a major recession. After all, there was almost uninterrupted economic growth from the mid 1980s until 2007, despite some pretty big shocks to the economy, including the technology bust and the 9/11 attacks. The policy failure was a very bad one, but it is hard to blame it on an excessive reliance on economic theory.
4. Give some credit to the Chicago School. Following the Great Depression and the war, there was a massive expansion of government regulation in areas such as transportation and telecommunications. George Stigler and Milton Friedman pointed to the problems created by such regulation and the tendency of regulators to be influenced or captured by the companies they are supposed to regulate. The deregulation movement started under Carter and was supported by Ted Kennedy as well as Republicans, and overall it has had beneficial effects. Why should the government decide which airline flies between two cities and what fare is charged? In studies of productivity in many industries and many countries, research by the McKinsey Global Institute (that I worked on) showed that poorly executed regulation has held back economic performance in many countries. Those policymakers that embraced deregulation and competition have seen the payoffs, including the UK, Australia, China and the United States.
5. As I said earlier, the successes of macroeconomic stabilization policy resulted in a complacency that contributed to the current crisis. The success of industry-level deregulation policies also caused problems. It encouraged the deregulation of the electricity sector without adequate safeguards and with disastrous consequences in California and elsewhere. It encouraged the deregulation of the financial sector and, more importantly, to a laxity by regulators who failed to appreciate excessive risk taking and the inherent instability of this sector. The consequences are the ones that Krugman describes so forcefully.
6. Krugman blames bad economic theory for the crisis, while I question whether economic theory really was as influential as he assumes. But at the least, economic theory did provide the intellectual rationale for policy and regulatory failures that helped get us into this mess.

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Krugman is right that economics is now more about the elegance or beauty of ideas and their mathematical exposition than about shedding light on real world problems.

As he notes, even the pragmatists among us (“the saltwater economists”) have not found a way to reconcile Keynesian theories with our continuing belief in the ability of individual markets to equilibrate supply and demand. Behavioral economics has helped to wean a new generation of economists from the earlier fixation on perfect rationality along with full and unbiased information, equally available to both buyer and seller in a market, but the microeconomic foundations of macroeconomics still need shoring up.

In the meantime, those of us who work in Washington in policy-advising or policy-making positions quickly learn that theoretical answers are nowhere near as useful as empirically-generated answers based on common sense conceptual frameworks.

The sad thing, in my view, is the resources that are wasted teaching the best and the brightest in today’s graduate schools that the ticket to success is a theoretically and mathematically derived answer to some trivial question. I agree that Krugman may have overstated or oversimplified his case in order to make it useful to the general reader but I very much welcome the debate I hope this will provoke.

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In thinking about the causes of the financial collapse I have been puzzled as to how so many knowledgeable people in Washington and on Wall Street did not realize that the long history of housing prices, at least since WWII, has followed a pretty steady trend and that the dramatic increase above trend that began in the early part of this decade simply could not be sustainable and had to revert to the mean – either gradually, or as we have seen, dramatically.

Krugman provides the answer: the dominant neo-classical economics doctrine equates value with price. If value equals price, then the price of housing – or any other commodity – is always priced appropriately. And if this is the case, then normal rules of lending and other financial tools generally will work. When it’s not, they don’t as we saw.

As such, Krugman is right to call for bringing the reality of human irrationality, institutions, culture, and technology, back into economics, as they once were before the mathemetization of economcs drove them out. But even with this, Krugman he can’t free himself from the dominant view that price equals value, when he states that “U.S. households have seen $13 trillion in wealth evaporate" in the recession.

But most of this 13 trillion didn't disappear. My house is still here. The companies in which my mutual funds own stock are still there . All that changed was the prices at which American asset owners can sell their assets fell by $11.2 trillion. But the prices that buyers have to pay for those assets also fell by $11.2 trillion.

This gets to the real challenge for neo-classical economics: refocusing the discipline on the real economy and not the monetary economy. Focusing on the forumer means asking a set of questions like, how are organizations innovating to develop new products, services and business models, and how can government help facilitate that process? How are entrepreneurs starting new high-growth companies? Are workers getting the skills they need to complement production changes in organizations? These and other questions get to the heart of what the new economics should be about: how does society create and expand real (as opposed to asset value) wealth.

This means not just bringing back institutions and people into economics as Krugman rightly argues that Keynesian economcis does. It means bringing back technology and innovation as central to the process of growth, not as neo-classical eocnomics holds, exogenous. So Keyneisanism is not the only alternative to the failures of neo-classical economics: innovation economics is (what has been also termed, new-growth theory, structuralist-evolutionary economics, or institutional economics).

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Professor Krugman's article, like much of his journalism, was hastily drafted and factually incorrect. He presents a caricature of the finance and economics professions and shows little knowlege of what actually went wrong with the markets and how much the sources of the crisis had been causes of concern by economists prior to the crisis.

One of the most humorous aspects of the article was its view that the efficient markets hypothesis was at the heart of the inability to see the bubble coming. If Krugman had bothered to read any of the finance journals for the past two decades he would have noticed a remarkable transformation of the profession away from adherence to the efficient markets hypothesis. Behaviorism is in, as are theories of market imperfections due to asymmetric information, and theories of agency (how money managers make purposeful investment errors because of conflicts between their interests and their clients'). It is hard to combine these ideas into an overarching theory of asset pricing, but in the past decade many scholars are starting to integrate asymmetric information theoretical perspectives from corporate finance (how firms raise funds) into models of asset pricing. So much for Krugman's knowledge of finance.

And Krugman also thinks that because he failed to see the subprime collapse coming that means the profession failed to see problems brewing. Not true. Many of us had been arguing for some time that Fannie's and Freddie's politically driven subsidies would create systemic risk in the mortgage market. Paul Krugman, on the other hand, argued as late as July 14, 2008, in his New York Times column, that F&F had no exposure to subprime, which he said followed from a legal prohibition of their involvement in subprime. This was siimply made up, like many of his columns. There is no such prohibition, and when the dust had settled it became clear that more than half of the total subprime exposure was in the hands of F&F. Of course, it was hard to know that prior to 2008, since F&F did such a good job disguising the magnitude of their subprime exposures with creative bookkeepiong. F&F crossed the Rubicon in 2004, when they decided to make markets in no docs mortgages, and produced a tripling of subprime originations in that year. Then, in 2006, when firms like Goldman and Deutsche were heading for the hills, given the obvious signs that the subprime market was iin for a tumble, F&F continued to make the market, leading to the continuation of peak origination volumes through the first quarter of 2007, which substantially increased losses from the crisis.

And many people also noted that the Fed was keeping money much too loose from 2002-2005. The Fed departed dramatically from its Taylor rule-determined levels of the fed funds rate throughout that period, often by more than a full percentage point below what would normally have been the fed funds rate, in light of inflation and unemployment at that time.

Also, some of us complained that Congress in 2006 was wrong to pressure, through its legislation that year, the ratings agencies to loosen their standards on subprime backed CDOs (this "anti-notching" initiative is still a little known fact). A dozen academics signed an open letter to the SEC in March 2007 complaining that its implementation of the new law would make an already excessively risky situation even worse.

And many of us had complained that prudential bank regulation, especially the Basel rules and the reliance on internal risk modeling by banks, was far too lax and did not measure risk accurately, and specifically, that it was far too permissive in its treatment of mortgages and their securitizations.

Indeed, the limited 10-year lookback rule for stress testing subprime securitizations was a subject of widespread criticism (the topic of my keynote lectue to an association of risk managers in February 2007), since that failed to build into the stress tests any reasonable possibility of a decline in housing prices. And I was not alone in that concern.

Professor Joseph Mason and Joshua Rosner also wrote papers in 2006 and early 2007 pointing to other flaws in the procedures used to rate subprime mortgage securitizations, and Rosner had been predicting a collapse of this market since mid-2006 on the basis of those concerns.

So much for Krugman's grasp of the facts.

All of which leads me to suggest a new word for the economics lexicon: "Krubbish": defined as the reporting by economists who care more about making headlines and scoring points for the left than they do about thoughtful public debate.

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Paul Krugman is broadly correct. Too many academic economists have been looking for truth under the lamppost rather than tackling the really difficult problems that do not lend themselves to elegant, mathematical solutions. Of course, as an economist and in order to be clear, Krugman had to simplify his own argument, and some will say oversimplify. The distinction between fresh water and salt water is broadly correct except that here on the Potomac the waters mix. I am sure that Krugman will offend many because some of the corrective trends, for example with respect to behavioral economics are already underway, but he has stirred up a good debate.

The question “how did economists get it so wrong?” is a difficult one to answer, but Paul Krugman has it exactly right.

In this case I would only add that he is modest in skipping over a point: during Japan’s lost decade of growth in the 1990s he forcefully made the inference that a severe economic breakdown was possible in a modern industrialized economy – a breakdown that was both reminiscent of the Great Depression and was outside the ken of modern macroeconomic theory. But macroeconomics went on as before.

Even the cartoons are good (except that I have never seen Olivier Blanchard in a double-breasted suit).