How Did Economists Get It So Wrong

How Did Economists Get It So Wrong?

By PAUL KRUGMAN

Published: September 2, 2009

I. MISTAKING BEAUTY FOR TRUTH

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 I

nternational 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 “centra

l

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

O

bama

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

usuall

y

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 mas

terwork, “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.

It’s

important

to

understand

that

Keynes

did

much

more

than

make

bold

assertions.

“The

General Theory” is a work of profound, deep analysis —

analysis that persuaded the best young

economists of the day. Yet the story of economics over the past half century is, to a large degree,

the story of a retreat from Keynesianism and a return to neoclassicism. The neoclassical revival

was initially led by Milton Friedman of the University of Chicago, who asserted as early as 1953

that neoclassical economics works well enough as a description of the way the economy actually

functions

to

be

“both

extremely

fruitful

and

deserving

of

much

confidence.”

But

what

about

depressions?

Friedman’s

counterattack

against

Keynes

b

egan

with

the

doctrine

known

as

monetarism.

Monetarists didn’t disagree in principle with the idea that a market economy needs deliberate

stabilization. “We are all Keynesians now,” Friedman once said, although he later claimed he was

quoted out of context. Monetarists asserted, however, that a very limited, circumscribed form of

government intervention

—

namely, instructing central banks to keep the nation’s money supply,

the sum of cash in circulation and bank deposits, growing on a steady path

—

is all t

hat’s required

to prevent depressions. Famously, Friedman and his collaborator, Anna Schwartz, argued that if

the Federal Reserve had done its job properly, the Great Depression would not have happened.

Later,

Friedman

made

a

compelling

case

against

any

deliberate

effort

by

government

to

push

unemployment below its “natural” level (currently thought to be about 4.8 percent in the United

States): excessively expansionary policies, he predicted, would lead to a combination of inflation

and

high

unemployment

—

a

prediction

that

was

borne

out

by

the

stagflation

of

the

1970s,

which greatly advanced the credibility of the anti- Keynesian movement.

Eventually, however, the anti-

Keynesian counterrevolution went far beyond Friedman’s position,

which came to seem relatively moderate compared with what his successors were saying. Among

financial economists, Keynes’s disparaging vision of financial markets as a “casino” was replaced

by “efficient market” theory, which asserted that financial markets always get asset pric

es right

given

the

available

information.

Meanwhile,

many

macroeconomists

completely

rejected

Keynes’s

framework

for

understanding

economic

slumps.

Some

returned

to

the

view

of

Schumpeter and other apologists for the Great Depression, viewing recessions as a good thing,

part of the economy’s adjustment to change. And even those not willing to go that far argued

that any attempt to fight an economic slump would do more harm than good.

Not

all

macroeconomists

were willing

to

go

down

this road:

many

became

self-described New

Keynesians, who continued to believe in an active role for the government. Yet even they mostly

accepted the notion that investors and consumers are rational and that markets generally get it

right.

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.

III. PANGLOSSIAN FINANCE

In the 1930s, financial markets, for obvious reasons, didn’t get much respect. Keynes compared

them

to

“those

newspaper

com

petitions

in

which

the

competitors

have

to

pick

out

the

six

prettiest faces from a hundred photographs, the prize being awarded to the competitor whose

choice

most

nearly

corresponds

to

the

average

preferences

of

the

competitors

as

a

whole;

so

that each competitor has to pick, not those faces which he himself finds prettiest, but those that

he thinks likeliest to catch the fancy of the other competitors.”

And Keynes considered it a very bad idea to let such markets, in which speculators spent their

time

ch

asing

one

another’s

tails,

dictate

important

business

decisions:

“When

the

capital

development of a country becomes a by- product of the activities of a casino, the job is likely to

be ill-

done.”

By

1970

or

so,

however,

the

study

of

financial

markets

seemed

to

have

been

taken

over

by

Voltaire’s Dr. Pangloss, who insisted that we live in the best of all possible worlds. Discussion of

investor

irrationality,

of

bubbles,

of

destructive

speculation

had

virtually

disappeared

from

academic discourse. The field wa

s dominated by the “efficient

-

market hypothesis,” promulgated

by

Eugene

Fama

of

the

University

of

Chicago,

which

claims

that

financial

markets

price

assets

precisely at their intrinsic worth given all publicly available information. (The price of a company

’s

stock, for example, always accurately reflects the company’s value given the information available

on

the

company’s

earnings,

its

business

prospects

and

so

on.)

And

by

the

1980s,

finance

economists, notably Michael Jensen of the Harvard Business School, were arguing that because

financial markets always get prices right, the best thing corporate chieftains can do, not just for

themselves but for the sake of the economy, is to maximize their stock prices. In other words,

finance

economists

believed

that

we

should

put

the

capital

development

of

the

nation

in

the

hands of what Keynes had called a “casino.”

It’s

hard

to

argue

that

this

transformation

in

the

profession

was

driven

by

events.

True,

the

memory

of

1929

was

gradually

receding,

but

there

continued

to

be

bull

markets,

with

widespread tales of speculative excess, followed by bear markets. In 1973-4, for example, stocks

lost

48

percent

of

their value.

And

the 1987

stock

crash,

in

which

the

Dow

plunged

nearly 23

percent

in

a

day

for

no

clear

reason,

should

have

raised

at

least

a

few

doubts

about

market

rationality.

These

events,

however,

which

Keynes

would

have

considered

evidence

of

the

unreliability

of

markets,

did

little

to

blunt

the

force

of

a

beautiful

idea.

The

theoretical

model

that

finance

economists developed by assuming that every investor rationally balances risk against reward

—

the

so-called

Capital

Asset

Pricing

Model,

or

CAPM

(pronounced

cap-em)

—

is

wonderfully

elegant. And if you accept its premises it’s also extremely useful. CAPM not

only tells you how to

choose your portfolio

—

even more important from the financial industry’s point of view, it tells

you

how

to

put

a

price

on

financial

derivatives,

claims

on

claims.

The

elegance

and

apparent

usefulness

of

the

new

theory

led

to

a

string

of

Nobel

prizes

for

its

creators,

and

many

of

the

theory’s

adepts

also

received

more

mundane

rewards:

Armed

with

their

new

models

and

formidable math skills

—

the more arcane uses of CAPM require physicist-level computations

—

mild-mannered

business-school

professors

could

and

did

become

Wall

Street

rocket

scientists,

earning Wall Street paychecks.

To be fair, finance theorists didn’t accept the efficient

-market hypothesis merely because it was

elegant, convenient and lucrative. They also produced a great deal of statistical evidence, which

at

first

seemed

strongly

supportive.

But

this

evidence

was

of

an

oddly

limited

form.

Finance

economists

rarely

asked

the

seemingly

obvious

(though

not

easily

answered)

question

of

whether

asset

prices

made

sense

given

real-world

fundamentals

like

earnings.

Instead,

they

asked only whether asset prices made sense given other asset prices. Larry Summers, now the

top

economic

adviser

in

the

Obama

administration,

once

mocked

finance

professors

with

a

parable

about

“ketchup

economists”

who

“have

shown

that

two

-quart

bottles

of

ketchup

invariably sell for exactly twice as much as one-

quart bottles of ketchup,” and conclude from this

that the ketchup market is perfectly efficient.

But neither this mockery nor more polite critiques from economists like Robert Shiller of Yale had

much effect. Finance theorists continued to believe that their models were essentially right, and

so

did

many

people

making

real-world

decisions.

Not

least

among

these

was

Alan

Greenspan,

who

was

then

the

Fed

chairman

and

a

long-time

supporter

of

financial

deregulation

whose

rejection of calls to rein in subprime lending or address the ever- inflating housing bubble rested

in large part on the belief that modern financial economics had everything under control. There

was a telling moment in 2005, at a conference held to honor Greenspan’s tenure at the Fed. One

brave

attendee,

RaghuramRajan

(of

the

University

of

Chicago,

surprisingly),

presented

a

paper

warning

that

the

financial

system

was

taking

on

potentially

dangerous

levels

of

risk.

He

was

mocked

by

almost

all

present

—

including,

by

the

way,

Larry

Summers,

who

dismissed

his

warnings as “misguided.”

By October of last year, however, Greenspan was admitting t

hat he was in a state of “shocked

disbelief,”

because

“the

whole

intellectual

edifice”

had

“collapsed.”

Since

this

collapse

of

the

intellectual edifice was also a collapse of real-world markets, the result was a severe recession

—

the

worst,

by

many

measures,

since

the

Great

Depression.

What

should

policy

makers

do?

Unfortunately, macroeconomics, which should have been providing clear guidance about how to

address the slumping economy, was in its own state of disarray.

IV. THE TROUBLE WITH MACRO

“

We have involved ourselves in a colossal muddle, having blundered in the control of a delicate

machine,

the

working

of

which

we

do

not

understand.

The

result

is

that

our

possibilities

of

wealth may run to waste for a time

—

perhaps for a long time.” So wrote John

Maynard Keynes in

an

essay

titled

“The

Great

Slump

of

1930,”

in

which

he

tried

to

explain

the

catastrophe

then

overtaking the world. And the world’s possibilities of wealth did indeed run to waste for a long

time; it took World War II to bring the Great Depression to a definitive end.

Why was Keynes’s diagnosis of the Great Depression as a “colossal muddle” so compelling at first?

And why did economics, circa 1975, divide into opposing camps over the value of Keynes’s views?

I

like

to

explain

the

essence

of

Keynesian

economics

with

a

true

story

that

also

serves

as

a

parable,

a

small- scale

version

of

the

messes

that

can

afflict

entire

economies.

Consider

the

travails of the Capitol Hill Baby- Sitting Co-op.

This co-op, whose problems were recounted in a 1977 article in The Journal of Money, Credit and

Banking,

was

an

association

of

about

150

young

couples

who

agreed

to

help

one

another

by

baby-

sitting for one another’s children when parents wanted a night out. To ensure that every

couple did its fair share of baby-sitting, the co-op introduced a form of scrip: coupons made out

of

heavy

pieces

of

paper,

each

entitling

the

bearer

to

one

half-hour

of

sitting

time.

Initially,

members

received

20

coupons

on

joining

and

were

required

to

return

the

same

amount

on

departing the group.

Unfortunately, it turned out that the co-

op’s members, on average, wanted to hold a reserve of

more than 20 coupons, perhaps, in case they should want to go out several times in a row. As a

result,

relatively

few

people

wanted

to

spend

their

scrip

and

go

out,

while

many

wanted

to

baby-sit so they could add to their hoard. But since baby-sitting opportunities arise only when

someone goes out for the night, this meant that baby- sitting jobs were hard to find, which made

members of the co-op even more reluctant to go out, making baby-sitting jobs even scarcer. . . .

In short, the co-op fell into a recession.

O.K., what do you think of this story? Don’t dismiss it as silly and trivial: economists have used

small-scale

examples

to

shed

light

on

big

questions

ever

since

Adam

Smith

saw

the

roots

of

economic

progress

in

a

pin

factory,

and

they’re

right

to

do

so.

The

question

is

whether

this

particular

example,

in

which

a

recession

is

a

problem

of

inadequate

demand

—

there

isn’t

enough

demand

for

baby- sitting

to

provide

jobs

for

everyone

who

wants

one

—

gets

at

the

essence of what happens in a recession.

Forty

years

ago

most

economists

would

have

agreed

with

this

interpretation.

But

since

then

macroeconomics has divided into two great factions: “saltwater” economists (mainly in coastal

U.S. universities), who have a more or less Keynesian vision of what recessions are all about; and

“freshwater” economists (mainly at inland schools), who consider that vision nonsense.

Freshwater

economists

are,

essentially,

neoclassical

purists.

They

believe

that

all

worthwhile

economic analysis starts from the premise that people are rational and markets work, a premise

violated by the story of the baby-sitting co-op. As they see it, a general lack of sufficient demand

isn’t possible, because prices always move to match supply with demand. If people want more

baby-

sitting coupons, the value of those coupons will rise, so that they’re worth, say, 40 minutes

of

baby-sitting

rather

than

half

an

hour

—

or,

equivalentl

y,

the

cost

of

an

hours’

baby

-sitting

would fall from 2 coupons to 1.5. And that would solve the problem: the purchasing power of the

coupons in circulation would have risen, so that people would feel no need to hoard more, and

there would be no recession.

But

don’t

recessions

look

like

periods

in

which

there

just

isn’t

enough

demand

to

employ

everyone

willing

to

work?

Appearances

can

be

deceiving,

say

the

freshwater

theorists.

Sound

economics, in their view, says that overall failures of demand can’t happ

en

—

and that means

that

they

don’t.

Keynesian

economics

has

been

“proved

false,”

Cochrane,

of

the

University

of

Chicago, says.

Yet recessions do happen. Why? In the 1970s the leading freshwater macroeconomist, the Nobel

laureate Robert Lucas, argued that recessions were caused by temporary confusion: workers and

companies had trouble distinguishing overall changes in the level of prices because of inflation or

deflation

from

changes

in

their

own

particular

business

situation.

And

Lucas

warned

that

any

attempt

to

fight

the

business

cycle

would

be

counterproductive:

activist

policies,

he

argued,

would just add to the confusion.

By the 1980s, however, even this severely limited acceptance of the idea that recessions are bad

things

had

been

rejected

by

many

freshwater

economists.

Instead,

the

new

leaders

of

the

movement, especially Edward Prescott, who was then at the University of Minnesota (you can

see where the freshwater moniker comes from), argued that price fluctuations and changes in

demand actually had nothing to do with the business

cycle. Rather, the business cycle reflects

fluctuations in the rate of technological progress, which are amplified by the rational response of

workers,

who

voluntarily

work

more

when

the

environment

is

favorable

and

less

wh

en

it’s

unfavorable. Unemployment is a deliberate decision by workers to take time off.

Put

baldly

like

that,

this

theory

sounds

foolish

—

was

the

Great

Depression

really

the

Great

Vacation?

And

to

be

honest,

I

think

it

really

is

silly.

But

the

basic

prem

ise

of

Prescott’s

“real

business

cycle”

theory

was

embedded

in

ingeniously

constructed

mathematical

models,

which

were mapped onto real data using sophisticated statistical techniques, and the theory came to

dominate the teaching of macroeconomics in many

university departments. In 2004, reflecting

the theory’s influence, Prescott shared a Nobel with Finn Kydland of Carnegie Mellon University.

Meanwhile,

saltwater

economists

balked.

Where

the

freshwater

economists

were

purists,

saltwater

economists

were

pragmatists.

While

economists

like

N.

Gregory

Mankiw

at

Harvard,