Sunday, September 6, 2009

Krugman: How Did Economists Get It So Wrong?

Paul Krugman's piece in the New York Times is quite long. But, it is a worthwhile read on economics history and a perspective of how the "dismal science" appears to be in need of a revamp as it attempts to explain and understand new economic challenges. Here are extracts:

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.
....

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.

Read the full piece here.

2 comments:

donplaypuks® said...

How did Economists get it so wrong? Is Krugman kidding or has he eaten on too many bagels?

Didn't Malthus sort of hint at it:

Population increases geometrically.

Food supply increases arithmetically.

USA snake oil voodo economics, Fed Reserve mumbo jumbo and GREED increases EXPONENTIALLY!!

QED.

dpp
We are all of 1 race, the Human Race

psikeyhackr said...

It's 40 years after the Moon landing and Krugman got his PhD in 1977. What has he said about the planned obsolescence of automobiles? How much have Americans lost on the depreciation of crapmobiles every year since 1969?

Our so called economic system depends on economists that can't do algebra. Double-entry accounting is 700 years old. How hard can it be with today's computers? When have our economists suggested that it be mandatory in the schools?

NO! We need to keep the consumers $tupid. That would screw up our game theory.

Economic Wargames