How Did Economists Get It So Wrong?

Paul Krugman had an essay in Sunday's New York Times magazine. He argued that modern macroeconomics was unable to see the crisis coming and that a new macroeconomics would have to start with Keynes. My colleague, Marty LaBarge, and I submitted the following letter to the editor of the magazine:

Paul Krugman offers a critique of modern macroeconomics in his essay, "How Did Economists Get It So Wrong?" He cites a concern for mathematical elegance over truth and reliance on efficient marekt theory as reasons for economists missing the instability in markets. But similar arguments could be made about the Keynesianism that Krugman advocates. In its heyday, Keynesianism included elegant mathematical models that demonstrated marekts are inherently unstable, and had its own version of an efficiency theory, only it was government that was efficient; a wise and good government could "fine-tune" the economy through appropriate fiscal policy, ignoring how real-world governments actually operated. While financial markets do fall short of perfection, the progression of the "perfect storm" of events that generated the worst recession since the Great Depression--the global saving glut, low interest rates, securitization, and government policy supporting homeownership--cannot be blamed on "extraordinary delusions and the madness of crowds."

Krugman pays no attention to the approximately twenty-year period of good macroeconomic performance known as the "Great Moderation." He also ignores "bubbles" that didn't lead to recessions. Something is at work besides irrational financial markets. The market system works well most of the time. Perhaps a key factor affecting whether a shock to the system or even 'irrational exuberance" leads to a serious recession is the level of buffer stocks held by households and firms. When savings exist and debt levels are not inordinately high, the economy adjusts to a shock. But when debt levels are high and savings low, the bursting of bubbles in houses and equities can turn into a severe recession. The crucial question now is whether taking on huge levels of government debt is the best way back to sustainable growth.

We don't know if the letter will be published or not.