There was a bubble in housing -- everybody knows that now. There was a bubble in finance itself -- the financial share of national income reached an all-time high just before the crisis; not too many people know this. There was even an academic bubble in the field of economics: the perceived quality of results in the field, reflected in the salaries and prestige of economics professors (e.g., relative to other social scientists), was as inflated as the price of any McMansion -- surely every university dean must understand this now? (Bayesian / Machine Learning comment: do these guys ever update? Or is it "All priors, all the time"?)
I suggest reading the whole thing. I've only excerpted the last three paragraphs below. (See also related essay by Richard Posner and this interview with Bill Janeway.)
How Did Economists Get It So Wrong?: ... So here’s what I think economists have to do. 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.
Many economists will find these changes deeply disturbing. It will be a long time, if ever, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. To some economists that will be a reason to cling to neoclassicism, despite its utter failure to make sense of the greatest economic crisis in three generations. This seems, however, like a good time to recall the words of H. L. Mencken: “There is always an easy solution to every human problem — neat, plausible and wrong.”
When it comes to the all-too-human problem of recessions and depressions, economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly. The vision that emerges as the profession rethinks its foundations may not be all that clear; it certainly won’t be neat; but we can hope that it will have the virtue of being at least partly right.
Related posts on Krugman's article from two thoughtful economists, Brad DeLong: Which economists got it so wrong? , Where does macro go from here? and Arnold Kling: Krugman vs Blanchard.
