Thursday, September 03, 2009

Krugman: the Economists have no clothes

Only Nixon could go to China, and only Paul Krugman could write this mea culpa for the discipline of economics.

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.


Carson C. Chow said...

Update on a subset of the probability space is only possible if the prior has nonzero support over it.

It seems that the Saltwater economists are updating. Even Mankiw thought there should be a stimulus, just that it should only be in tax cuts. I doubt the freshwater economists can update. Fama, Mulligan, etc. will go to the grave believing in efficient markets.

LondonYoung said...

I think Kruggy meant to say "Extraordinary Popular Delusions and the Madness of Crowds" - an absolute must read by Charles Mackay. From Amazon: "We may think that the Great Crash of 1929, junk bonds of the '80s, and over-valued high-tech stocks of the '90s are peculiarly 20th century aberrations, but Mackay's classic--first published in 1841--shows that the madness and confusion of crowds knows no limits, and has no temporal bounds."

zzzhou said...

Crowds aren't as mad as it seems. The pain of losing half of one's savings when everyone else is prospering is greater than that of the same loss when everyone else is also suffering. We follow the herd to satisfy a psychological need. It's a hedge against being left out. Put it into the model.

Seth said...


I don't think the 'madness' is being applied to the anger of people who have lost their savings. It refers to the 'crazy' or 'irrational' behavior of following the crowd into activities like 'flipping' houses. The tendency to do it because 'everybody' is doing it.

Our herding behavior has adaptive benefits, but it often amplifies our mistakes, particularly in areas like the business cycle where the wavelengths of the phenomena (cycles) are too long for our brains' iterative learning mechanisms to really gain traction. By the time the 'lesson' has been 'learned', it's time to hand over to the younger generation who didn't have the traumatic learning experience.

LondonYoung said...

I'll mention one other thing.
Kruggy is a top notch economist, but he is also a left-wing partisan. The Obama administration is enacting enormous spending which is increasing the U.S. debt burden by 30% in a single year. This is being called "stimulus".

That "stimulus" label requires an affection for Keynesian economics and a rejection of any kind of Ricardian equivalence. I suspect that defense of this label is what is really on Krug's mind. And I suspect that he is jumping to the defense at this point because the realization is setting in that Obama has now spent so much that he is going to have to break his "no tax increase for most Americans" pledge.
If he ends up breaking that pledge without affecting the economic cycle both he and Krugs, who argued for even more "stimulus", are not going to be remembered well.
In January, when supporting the stimulus package, the administration argued that without it unemployment would go to 8%! Oops.

Ian Smith said...

Hmmm. Astrology (economics) can't predict the future? But I thought...

The most striking thing about "the science of economics" compared to engineering and other usefull fields is the gross overrepresentation in economics of a certain very powerful ethnic minority group.


Who is "us"? What is "our"? You're a herd animal yourself. MOOOOO.

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LondonYoung said...

An example in the WSJ today of the political-economic argument that Krugs is attempting to address:

"Keynesian thinking was ... discredited in practice in the 1970s, when the Keynesians could neither explain nor cure the double-digit inflation, interest rates, and unemployment that resulted from their policies. Ronald Reagan's decision to dump Keynesianism in favor of supply-side policies—which emphasize incentives for investment—produced a 25-year economic boom."

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