Wednesday, September 9, 2009

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.


  1. Great response to the article Professor Lunn. I hope the response gets published.

    I on the other hand don't disagree with Paul Krugman that much, but I don't know that much about the subject to match your experience either. Krugman seems over critical of Monetarists in general and his past papers and books say a lot about that. But at the same time, the way the whole subject of economic was (is?) progressing needed to be checked. There was too much emphasis on mathematics and modeling, all assuming that there is perfect information in the market and that consumers all rational (make decisions based on facts). I know for sure that I am not always rational and make stupid decisions all the time, so I don't assume other people are any different.

    I feel the movement towards deregulation, especially in the financial market, went too far. New areas of innovations in the financial market that have led investors to go after short term gains have made the market vulnerable to such massive readjustments (or even vulnerable to false equilibrium based on false information).

    If the financial market consisted of investors like Warren Buffet who are seeking long term gains then I would say that keeping government regulators out of the financial markets is the way to go. But I believe there are more investors looking for short term gain than long term. And when institutions as big as Bank of America, JP Morgan and Goldman Sachs, are the once making these decisions based on short term gains, we are going to many more financial crisis like this one in the future. Goldman's executives have every right to make their decisions and the government should not be listening in on their board meetings. But if their decisions can lead to a financial crisis as big as this one and can create an economic crisis that can affect the livelihood of billions of people around the world, then I would say there should be some way of checking this short term reward seeking.

    There seems to be an opinion among many market economists and business leaders that suggest that slightest of regulations might stifle enterprise and innovations, I tend to believe that there needs to clearly define rules especially when our livelihood is at stake here.

    My analogy to this crisis: We create a game of soccer where we separated an area in the field where there were no rules, where players could tackle each other without any penalty, where there were no referees. If players get injured in the area where there are no rules, there will still be injured if they come out to the part where there are rules. We cannot assume that that small area with rules will not have any impact on the rest of the game because that area consists just 1% of the field.

    I am not saying that we can blindly follow Keynesian ideas. We need to find a middle ground where there are enough checks and balances in the system to avoid such massive irregularities and risk taking, and at the same time limit the role of government so that we don’t really become a command economy.


  2. In response to Vidhan:

    You expressed concern that deregulation went too far, but when exactly did this deregulation occur? In my view the blame should be with the government, not the companies looking to make profit. You say that sometimes you make bad decisions, but do you really think the government could make better ones for you?

    It is already in an institution's best interest to not lie, cheat, and steal because no one will do business with them if they are caught. More regulation isn't going to give people more of an incentive, it's just going to distort the market more. When firms become too risky they lose money and might even go out of business (unless of course they are bailed out). Companies failing can be a good thing for a market as it shows others how not to run their business.

    We shouldn't even be thinking about Keynesian ideas, Friedman had the right idea. At least that's my opinion anyway.

  3. I will write more about deregulation and possible new regulations later. Keep in mind that regulation tends to be reactionary. That is, it tries to solve a problem that was recently discovered but does not do well at anticipating where new problems may arise. In the recent financial crisis, regulations existed but regulators tended to think that we had a new economy or that the Fed had solved the problem of instability, so the regulators didn't look into the situation closely. After all, regulators are human beings also.