Economics and the Crisis

Paul Krugman has a long article discussing the role of economists in the crisis. Krugman argues that macroeconomics has gotten it very wrong. His basic indictment:

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, thatstocks 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.

The explanation is becoming fairly conventional. The problem is that mathematization of the field.

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 article is worth reading in full, but Krugman's attack lacks focus I think. His attack is too broad, and thus the worthy parts are offset by the desire to blame everything he does not like.

For example, it is just not fair to argue that economists accepted the efficient markets hypothesis or the belief in market efficiency for personal gain:

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.

What about the evidence from financial markets that demonstrates the difficulty of beating the market? Most empirical studies, especially the early ones, were quite clear on this (see, for example, here). This is especially true for the weak form of the hypothesis that says that asset prices incorporate all publicly available information.

Krugman also mis-characterizes why fresh-water and salt-water economists reconciliated. He writes:

Somewhat surprisingly, however, between around 1985 and 2007 the disputes between freshwater and saltwater economists were mainly about theory, not action. The reason, I believe, is that New Keynesians, unlike the original Keynesians, didn’t think fiscal policy — changes in government spending or taxes — was needed to fight recessions. They believed that monetary policy, administered by the technocrats at the Fed, could provide whatever remedies the economy needed.

This misses the story. What happened is that fresh-water economists started to incorporate market frictions in their models, especially those that come from search. Meanwhile, salt-water economists adopted the methodology, using dynamic models with optimizing agents to study economies with other types of market frictions. An agreement to study the quantitative effects of policies made it easier for macroeconomists to talk. This is much closer to what happened.

How about Krugman's claim that macroeconomists should have predicted the crisis?

In recent, rueful economics discussions, an all-purpose punch line has become “nobody could have predicted. . . .” It’s what you say with regard to disasters that could have been predicted, should have been predicted and actually were predicted by a few economists who were scoffed at for their pains.

Take, for example, the precipitous rise and fall of housing prices. Some economists, notably Robert Shiller, did identify the bubble and warn of painful consequences if it were to burst.

Of course it is not really clear that Shiller actually predicted that housing prices would decline nationally, as Falkenblog has noted. Moreover, a bubble continues precisely because the belief that asset prices follow a bubble is not common knowledge. Once it becomes common knowledge traders sell against the bubble. The bubble continues precisely because nobody knows when enough agents realize this. This is the important lesson from Abreu and Brunnermaier (the latter is Krugman's colleague, so he should be aware of this). Now suppose that there is a difference of opinion concerning the likelihood we are on a bubble path. What are policymakers to do? If they try to prick the bubble they will be blamed for the consequences. There is a political agency problem here.

The person who gets the most credit for predicting the crisis is Nouriel Roubini. He did predict crisis, the one that many economists did expect. But that was a currency crisis due to our excessive current account deficits. This was quite a rational fear. As for the excessive risk in the banking system, it seems that Raghuram Rajan was the only major economist who talked about this (there was some very good work at the BIS that was also ignored). And as Krugman notes in his article, when Rajan made these warnings even Larry Summers belittled him. Why was this the case? I suspect that most economists understood the basics of securitization, but could not believe how much of the CDO's banks were keeping on their books or in special investment vehicles they were responsible for. Since the latter are off-balance sheet, they are precisely organized to fool analysts.

What economists did miss is an important point made by Posner in his book, A Failure of Capitalism. Suppose we have regulations that prevent some type of crisis. Over time, if the policies are successful, the likelihood of seeing a crisis will recede. So the benefits of the regulations will be less apparent. But the costs of the regulation will not be reduced. So a cost-benefit analysis of beneficial regulations will seem to signal inefficiency. This increases the political support for eliminating the beneficial regulations. And this will make a crisis more likely.

This leads to another interesting point about economics. Normally economics works through negative feedback loops. When demand for a good falls so does its price. The fall in the price reduces the extent of the fall in sales and signals producers to produce other things. Negative feedback is what makes the equilibrium hypothesis useful. But what happens when the economy is so far out of kilter that we have positive feedback loops? This is what happened when the housing bubble burst. The fall in asset prices led to a deterioration of bank balance sheets and less lending. This hurt investment and production and incomes declined. So people could not purchase homes that were much cheaper. This is positive feedback, and it is what turned the asset bubble into the great recession.

Notice that after many asset bubbles burst negative feedback loops operated. Think of the 1987 crash or the end of the tech bubble. These had little economy-wide effects because of negative feedback. But in rare cases we do get positive feedback. Yet if these cases are so rare most of the data we operate with will not display it. So most of our experience, and most of our analysis will be conducted using data generated by negative feedback behavior. It is not surprising that we are not well-prepared for positive feedback loops. If we were it would mean we had experienced many more crises.

One could then blame economists for focusing so much on normal times and ignoring how the economy works outside the corridor (see my previous post on the Corridor hypothesis). But given how rare depressions have been was this such an unwise strategy?

Another important point Krugman makes is that macro failed to incorporate finance sufficiently. This is an important criticism, but I doubt the reason is the efficient markets hypothesis. It stems much more from the use of representative agent models. These make it hard to model finance. I think it is the complexity rather than the obtuseness of economists that led to this result.