Why Economists Messed Up

The biggest thing in economics today is Paul Krugman’s “How Did Economists Get It So Wrong?” in the New York Times Magazine. If you have any interest in macroeconomic policy, you should read it.

For one thing, the illustrations by Jason Lutes are quite entertaining.

More important, though, is Paul’s evaluation of how we economists missed the 800-pound gorilla in the room. He fingers three suspects:

  • Mistaking beauty for truth. I.e., too much reliance on elegant, solvable, mathematical models in which economic players are rational and markets adjust to shocks easily. These models are a joy to play with — and provide important insights — but they miss messy truths about the actual economy.
  • Excess confidence in financial markets. He argues that widespread acceptance of the efficient markets hypothesis (the idea that asset prices incorporate all information and thus get prices “right”) left us blind to the risks of asset bubbles.
  • The limits of mainstream macroeconomics. This critique is harder to summarize, but in a nutshell he argues that (a) some economists have (incorrectly) embraced the classical view that the government can’t and shouldn’t try to moderate the business cycle and (b) the larger body of mainstream of economists have (correctly) embraced the Keynesian view that the government can try to moderate the business cycle but have (incorrectly) concluded that the Federal Reserve is the only appropriate tool to do so.

I think each of these charges has merit, with one caveat. Back in graduate school, I was indeed taught that monetary policy was the preferred tool for addressing economic weakness (e.g., because of policy lags and concerns about the political economy of what passes as fiscal stimulus from the Congress). In my years in Washington, however, I have met many economists, of the left, right, and center, who believe in fiscal policy as well. Indeed, in policy circles, the idea of fiscal stimulus was active in 2001, 2003, 2008, and 2009, each of which witnessed tax cuts (and, in the most recent case, spending increases) that were partly or wholly passed in the name of stimulus. One can debate the merits of those acts, but the concept of fiscal stimulus has been alive and kicking.

Paul’s recommendations for the way forward for economists:

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.

On his final point, I should note that one of the leading thinkers on the links between finance and macro is none other than Ben Bernanke, current (and, one hopes, future) chairman of the Federal Reserve. That’s one of the reasons he’s the right person for the job.

About Donald Marron 294 Articles

Donald Marron is an economist in the Washington, DC area. He currently speaks, writes, and consults about economic, budget, and financial issues.

From 2002 to early 2009, he served in various senior positions in the White House and Congress including: * Member of the President’s Council of Economic Advisers (CEA) * Acting Director of the Congressional Budget Office (CBO) * Executive Director of Congress’s Joint Economic Committee (JEC)

Before his government service, Donald had a varied career as a professor, consultant, and entrepreneur. In the mid-1990s, he taught economics and finance at the University of Chicago Graduate School of Business. He then spent about a year-and-a-half managing large antitrust cases (e.g., Pepsi vs. Coke) at Charles River Associates in Washington, DC. After that, he took the plunge into the world of new ventures, serving as Chief Financial Officer of a health care software start-up in Austin, TX. After that fascinating experience, he started his career in public service.

Donald received his Ph.D. in Economics from the Massachusetts Institute of Technology and his B.A. in Mathematics a couple miles down the road at Harvard.

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1 Comment on Why Economists Messed Up

  1. The answer to the question of why economists failed to diagnose the building problems that now plague the global economy is dealt with in the curent issue of the International Journal of Social Economics. This issue, to which I contributed a paper on the political economy of Benjamin Franklin, focuses on the theoretical contributions of the 19th century writer Henry George. Most of the contributing authors are economics professors who have come to appreciate Henry George’s analysis of business cycles and the central importance property markets play. John C. Medaille’s paper, “Jusitce and Mr. George,” is a gripping analysis of what is wrong with neo-classical economics and how it got so wrong. Other papers included in the volume as just as important. I hope it finds a broad readership.

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