Krugman: Getting Economists Wrong

Mon, 07 Sep 2009 21:53:37 +0000

Paul Krugman's essay in yesterday's New York Times magazine has me puzzled. Specifically, I think the longstanding divide between the "freshwater" (i.e. Chicago and Minnesota) and "saltwater" (e.g., Harvard, MIT, Princeton, Stanford and other coastal universities) schools of macroeconomics is of little relevance to an explanation of "How Did Economists Get It So Wrong?" Here is what Krugman claims that economists got wrong:

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.

I spend a lot of time with economists. I haven't met one who was "blind to the very possibility of catastrophic failures in a market economy." I also haven't met one who insists that "stocks and other assets were always priced just right." Speaking for myself, I misunderstood two things about financial markets:

1) I had no idea that the major ratings agencies like Moody's and S&P were in on the con. I thought they made their money by preserving their reputations for honest assessments above all else. Many elements of financial innovation and regulation were dependent on a AAA rating being a AAA rating. If you would have shown most economists I know that the ratings were bogus, or if you had even convinced them that the ratings were being paid for by the sellers of the securities, not the buyers, then basic economic theory would have suggested that the problems of biased ratings would have been severe. In other words, this was not a failure of economic theory. The failure was empirical -- we mistakenly believed that risky assets were being appropriately classified.

2) I had too little appreciation for the way ex ante distinctions -- like whether a financial institutions liabilities were federally insured -- would be of little relevance in the way the government dealt with the potential insolvency of financial institutions. If we were going to bail out Bear Stearns, AIG, and through them, Government Sachs and the rest, then we should have been regulating them much more tightly and charging them insurance premiums. I thought that uninsured and unregulated meant that the public trough was closed. I was wrong. Had I realized this earlier, I would have been much more concerned about the goings-on in financial markets than I previously was.

Krugman's essay is written as if the failure of economists was a failure of the profession to correctly advise policy makers on what to do, either before the financial crisis or during and after the recession. I don't see the policy advice being given to recent Presidents as being too tainted by this controversy. The Chicago School may not be of much help in getting out of the recession quickly, but neither has it been at the center of policy making. Consider the recent members of the Council of Economic Advisers -- there is hardly a Chicago-school devotee in the mix. Presidents over the last two decades have been getting their advice from academic economists who generally believe that the government has a role to play in making up for weak demand during a recession. If we failed to provide good advice, it has nothing to do with our profession's internal disagreements.