PK on the state of economics
Source Jim Devine
Date 09/09/04/00:09

September 6, 2009 [the Sunday New York TIMES MAGAZINE]
How Did Economists Get It So Wrong?


It’s hard to believe now, but not long ago economists were
congratulating themselves over the success of their field. Those
successes — or so they believed — were both theoretical and practical,
leading to a golden era for the profession. On the theoretical side,
they thought that they had resolved their internal disputes. Thus, in
a 2008 paper titled “The State of Macro” (that is, macroeconomics, the
study of big-picture issues like recessions), Olivier Blanchard of
M.I.T., now the chief economist at the International Monetary Fund,
declared that “the state of macro is good.” The battles of yesteryear,
he said, were over, and there had been a “broad convergence of
vision.” And in the real world, economists believed they had things
under control: the “central problem of depression-prevention has been
solved,” declared Robert Lucas of the University of Chicago in his
2003 presidential address to the American Economic Association. In
2004, Ben Bernanke, a former Princeton professor who is now the
chairman of the Federal Reserve Board, celebrated the Great Moderation
in economic performance over the previous two decades, which he
attributed in part to improved economic policy making.

Last year, everything came apart.

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, that stocks 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

And in the wake of the crisis, the fault lines in the economics
profession have yawned wider than ever. Lucas says the Obama
administration’s stimulus plans are “schlock economics,” and his
Chicago colleague John Cochrane says they’re based on discredited
“fairy tales.” In response, Brad DeLong of the University of
California, Berkeley, writes of the “intellectual collapse” of the
Chicago School, and I myself have written that comments from Chicago
economists are the product of a Dark Age of macroeconomics in which
hard-won knowledge has been forgotten.

What happened to the economics profession? And where does it go from here?

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 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.

Unfortunately, this romanticized and sanitized vision of the economy
led most economists to ignore all the things that can go wrong. They
turned a blind eye to the limitations of human rationality that often
lead to bubbles and busts; to the problems of institutions that run
amok; to the imperfections of markets — especially financial markets —
that can cause the economy’s operating system to undergo sudden,
unpredictable crashes; and to the dangers created when regulators
don’t believe in regulation.

It’s much harder to say where the economics profession goes from here.
But what’s almost certain is that economists will have to learn to
live with messiness. That is, they will have to acknowledge the
importance of irrational and often unpredictable behavior, face up to
the often idiosyncratic imperfections of markets and accept that an
elegant economic “theory of everything” is a long way off. In
practical terms, this will translate into more cautious policy advice
— and a reduced willingness to dismantle economic safeguards in the
faith that markets will solve all problems.


The birth of economics as a discipline is usually credited to Adam
Smith, who published “The Wealth of Nations” in 1776. Over the next
160 years an extensive body of economic theory was developed, whose
central message was: Trust the market. Yes, economists admitted that
there were cases in which markets might fail, of which the most
important was the case of “externalities” — costs that people impose
on others without paying the price, like traffic congestion or
pollution. But the basic presumption of “neoclassical” economics
(named after the late-19th-century theorists who elaborated on the
concepts of their “classical” predecessors) was that we should have
faith in the market system.

This faith was, however, shattered by the Great Depression. Actually,
even in the face of total collapse some economists insisted that
whatever happens in a market economy must be right: “Depressions are
not simply evils,” declared Joseph Schumpeter in 1934 — 1934! They
are, he added, “forms of something which has to be done.” But many,
and eventually most, economists turned to the insights of John Maynard
Keynes for both an explanation of what had happened and a solution to
future depressions.

Keynes did not, despite what you may have heard, want the government
to run the economy. He described his analysis in his 1936 masterwork,
“The General Theory of Employment, Interest and Money,” as “moderately
conservative in its implications.” He wanted to fix capitalism, not
replace it. But he did challenge the notion that free-market economies
can function without a minder, expressing particular contempt for
financial markets, which he viewed as being dominated by short-term
speculation with little regard for fundamentals. And he called for
active government intervention — printing more money and, if
necessary, spending heavily on public works — to fight unemployment
during slumps.

It’s important to understand that Keynes did much more than make bold
assertions. “The General Theory” is a work of profound, deep analysis
— analysis that persuaded the best young economists of the day. Yet
the story of economics over the past half century is, to a large
degree, the story of a retreat from Keynesianism and a return to
neoclassicism. The neoclassical revival was initially led by Milton
Friedman of the University of Chicago, who asserted as early as 1953
that neoclassical economics works well enough as a description of the
way the economy actually functions to be “both extremely fruitful and
deserving of much confidence.” But what about depressions?

Friedman’s counterattack against Keynes began with the doctrine known
as monetarism. Monetarists didn’t disagree in principle with the idea
that a market economy needs deliberate stabilization. “We are all
Keynesians now,” Friedman once said, although he later claimed he was
quoted out of context. Monetarists asserted, however, that a very
limited, circumscribed form of government intervention — namely,
instructing central banks to keep the nation’s money supply, the sum
of cash in circulation and bank deposits, growing on a steady path —
is all that’s required to prevent depressions. Famously, Friedman and
his collaborator, Anna Schwartz, argued that if the Federal Reserve
had done its job properly, the Great Depression would not have
happened. Later, Friedman made a compelling case against any
deliberate effort by government to push unemployment below its
“natural” level (currently thought to be about 4.8 percent in the
United States): excessively expansionary policies, he predicted, would
lead to a combination of inflation and high unemployment — a
prediction that was borne out by the stagflation of the 1970s, which
greatly advanced the credibility of the anti-Keynesian movement.

Eventually, however, the anti-Keynesian counterrevolution went far
beyond Friedman’s position, which came to seem relatively moderate
compared with what his successors were saying. Among financial
economists, Keynes’s disparaging vision of financial markets as a
“casino” was replaced by “efficient market” theory, which asserted
that financial markets always get asset prices right given the
available information. Meanwhile, many macroeconomists completely
rejected Keynes’s framework for understanding economic slumps. Some
returned to the view of Schumpeter and other apologists for the Great
Depression, viewing recessions as a good thing, part of the economy’s
adjustment to change. And even those not willing to go that far argued
that any attempt to fight an economic slump would do more harm than

Not all macroeconomists were willing to go down this road: many became
self-described New Keynesians, who continued to believe in an active
role for the government. Yet even they mostly accepted the notion that
investors and consumers are rational and that markets generally get it

Of course, there were exceptions to these trends: a few economists
challenged the assumption of rational behavior, questioned the belief
that financial markets can be trusted and pointed to the long history
of financial crises that had devastating economic consequences. But
they were swimming against the tide, unable to make much headway
against a pervasive and, in retrospect, foolish complacency.


In the 1930s, financial markets, for obvious reasons, didn’t get much
respect. Keynes compared them to “those newspaper competitions in
which the competitors have to pick out the six prettiest faces from a
hundred photographs, the prize being awarded to the competitor whose
choice most nearly corresponds to the average preferences of the
competitors as a whole; so that each competitor has to pick, not those
faces which he himself finds prettiest, nor even those that he thinks
likeliest to catch the fancy of the other competitors.”

And Keynes considered it a very bad idea to let such markets, in which
speculators spent their time chasing one another’s tails, dictate
important business decisions: “When the capital development of a
country becomes a by-product of the activities of a casino, the job is
likely to be ill-done.”

By 1970 or so, however, the study of financial markets seemed to have
been taken over by Voltaire’s Dr. Pangloss, who insisted that we live
in the best of all possible worlds. Discussion of investor
irrationality, of bubbles, of destructive speculation had virtually
disappeared from academic discourse. The field was dominated by the
“efficient-market hypothesis,” promulgated by Eugene Fama of the
University of Chicago, which claims that financial markets price
assets precisely at their intrinsic worth given all publicly available
information. (The price of a company’s stock, for example, always
accurately reflects the company’s value given the information
available on the company’s earnings, its business prospects and so
on.) And by the 1980s, finance economists, notably Michael Jensen of
the Harvard Business School, were arguing that because financial
markets always get prices right, the best thing corporate chieftains
can do, not just for themselves but for the sake of the economy, is to
maximize their stock prices. In other words, finance economists
believed that we should put the capital development of the nation in
the hands of what Keynes had called a “casino.”

It’s hard to argue that this transformation in the profession was
driven by events. True, the memory of 1929 was gradually receding, but
there continued to be bull markets, with widespread tales of
speculative excess, followed by bear markets. In 1973-4, for example,
stocks lost 48 percent of their value. And the 1987 stock crash, in
which the Dow plunged nearly 23 percent in a day for no clear reason,
should have raised at least a few doubts about market rationality.

These events, however, which Keynes would have considered evidence of
the unreliability of markets, did little to blunt the force of a
beautiful idea. The theoretical model that finance economists
developed by assuming that every investor rationally balances risk
against reward — the so-called Capital Asset Pricing Model, or CAPM
(pronounced cap-em) — is wonderfully elegant. And if you accept its
premises it’s also extremely useful. CAPM not only tells you how to
choose your portfolio — even more important from the financial
industry’s point of view, it tells you how to put a price on financial
derivatives, claims on claims. The elegance and apparent usefulness of
the new theory led to a string of Nobel prizes for its creators, and
many of the theory’s adepts also received more mundane rewards: Armed
with their new models and formidable math skills — the more arcane
uses of CAPM require physicist-level computations — mild-mannered
business-school professors could and did become Wall Street rocket
scientists, earning Wall Street paychecks.

To be fair, finance theorists didn’t accept the efficient-market
hypothesis merely because it was elegant, convenient and lucrative.
They also produced a great deal of statistical evidence, which at
first seemed strongly supportive. But this evidence was of an oddly
limited form. Finance economists rarely asked the seemingly obvious
(though not easily answered) question of whether asset prices made
sense given real-world fundamentals like earnings. Instead, they asked
only whether asset prices made sense given other asset prices. Larry
Summers, now the top economic adviser in the Obama administration,
once mocked finance professors with a parable about “ketchup
economists” who “have shown that two-quart bottles of ketchup
invariably sell for exactly twice as much as one-quart bottles of
ketchup,” and conclude from this that the ketchup market is perfectly

But neither this mockery nor more polite critiques from economists
like Robert Shiller of Yale had much effect. Finance theorists
continued to believe that their models were essentially right, and so
did many people making real-world decisions. Not least among these was
Alan Greenspan, who was then the Fed chairman and a long-time
supporter of financial deregulation whose rejection of calls to rein
in subprime lending or address the ever-inflating housing bubble
rested in large part on the belief that modern financial economics had
everything under control. There was a telling moment in 2005, at a
conference held to honor Greenspan’s tenure at the Fed. One brave
attendee, Raghuram Rajan (of the University of Chicago, surprisingly),
presented a paper warning that the financial system was taking on
potentially dangerous levels of risk. He was mocked by almost all
present — including, by the way, Larry Summers, who dismissed his
warnings as “misguided.”

By October of last year, however, Greenspan was admitting that he was
in a state of “shocked disbelief,” because “the whole intellectual
edifice” had “collapsed.” Since this collapse of the intellectual
edifice was also a collapse of real-world markets, the result was a
severe recession — the worst, by many measures, since the Great
Depression. What should policy makers do? Unfortunately,
macroeconomics, which should have been providing clear guidance about
how to address the slumping economy, was in its own state of disarray.


“We have involved ourselves in a colossal muddle, having blundered in
the control of a delicate machine, the working of which we do not
understand. The result is that our possibilities of wealth may run to
waste for a time — perhaps for a long time.” So wrote John Maynard
Keynes in an essay titled “The Great Slump of 1930,” in which he tried
to explain the catastrophe then overtaking the world. And the world’s
possibilities of wealth did indeed run to waste for a long time; it
took World War II to bring the Great Depression to a definitive end.

Why was Keynes’s diagnosis of the Great Depression as a “colossal
muddle” so compelling at first? And why did economics, circa 1975,
divide into opposing camps over the value of Keynes’s views?

I like to explain the essence of Keynesian economics with a true story
that also serves as a parable, a small-scale version of the messes
that can afflict entire economies. Consider the travails of the
Capitol Hill Baby-Sitting Co-op.

This co-op, whose problems were recounted in a 1977 article in The
Journal of Money, Credit and Banking, was an association of about 150
young couples who agreed to help one another by baby-sitting for one
another’s children when parents wanted a night out. To ensure that
every couple did its fair share of baby-sitting, the co-op introduced
a form of scrip: coupons made out of heavy pieces of paper, each
entitling the bearer to one half-hour of sitting time. Initially,
members received 20 coupons on joining and were required to return the
same amount on departing the group.

Unfortunately, it turned out that the co-op’s members, on average,
wanted to hold a reserve of more than 20 coupons, perhaps, in case
they should want to go out several times in a row. As a result,
relatively few people wanted to spend their scrip and go out, while
many wanted to baby-sit so they could add to their hoard. But since
baby-sitting opportunities arise only when someone goes out for the
night, this meant that baby-sitting jobs were hard to find, which made
members of the co-op even more reluctant to go out, making
baby-sitting jobs even scarcer. . . .

In short, the co-op fell into a recession.

O.K., what do you think of this story? Don’t dismiss it as silly and
trivial: economists have used small-scale examples to shed light on
big questions ever since Adam Smith saw the roots of economic progress
in a pin factory, and they’re right to do so. The question is whether
this particular example, in which a recession is a problem of
inadequate demand — there isn’t enough demand for baby-sitting to
provide jobs for everyone who wants one — gets at the essence of what
happens in a recession.

Forty years ago most economists would have agreed with this
interpretation. But since then macroeconomics has divided into two
great factions: “saltwater” economists (mainly in coastal U.S.
universities), who have a more or less Keynesian vision of what
recessions are all about; and “freshwater” economists (mainly at
inland schools), who consider that vision nonsense.

Freshwater economists are, essentially, neoclassical purists. They
believe that all worthwhile economic analysis starts from the premise
that people are rational and markets work, a premise violated by the
story of the baby-sitting co-op. As they see it, a general lack of
sufficient demand isn’t possible, because prices always move to match
supply with demand. If people want more baby-sitting coupons, the
value of those coupons will rise, so that they’re worth, say, 40
minutes of baby-sitting rather than half an hour — or, equivalently,
the cost of an hours’ baby-sitting would fall from 2 coupons to 1.5.
And that would solve the problem: the purchasing power of the coupons
in circulation would have risen, so that people would feel no need to
hoard more, and there would be no recession.

But don’t recessions look like periods in which there just isn’t
enough demand to employ everyone willing to work? Appearances can be
deceiving, say the freshwater theorists. Sound economics, in their
view, says that overall failures of demand can’t happen — and that
means that they don’t. Keynesian economics has been “proved false,”
Cochrane, of the University of Chicago, says.

Yet recessions do happen. Why? In the 1970s the leading freshwater
macroeconomist, the Nobel laureate Robert Lucas, argued that
recessions were caused by temporary confusion: workers and companies
had trouble distinguishing overall changes in the level of prices
because of inflation or deflation from changes in their own particular
business situation. And Lucas warned that any attempt to fight the
business cycle would be counterproductive: activist policies, he
argued, would just add to the confusion.

By the 1980s, however, even this severely limited acceptance of the
idea that recessions are bad things had been rejected by many
freshwater economists. Instead, the new leaders of the movement,
especially Edward Prescott, who was then at the University of
Minnesota (you can see where the freshwater moniker comes from),
argued that price fluctuations and changes in demand actually had
nothing to do with the business cycle. Rather, the business cycle
reflects fluctuations in the rate of technological progress, which are
amplified by the rational response of workers, who voluntarily work
more when the environment is favorable and less when it’s unfavorable.
Unemployment is a deliberate decision by workers to take time off.

Put baldly like that, this theory sounds foolish — was the Great
Depression really the Great Vacation? And to be honest, I think it
really is silly. But the basic premise of Prescott’s “real business
cycle” theory was embedded in ingeniously constructed mathematical
models, which were mapped onto real data using sophisticated
statistical techniques, and the theory came to dominate the teaching
of macroeconomics in many university departments. In 2004, reflecting
the theory’s influence, Prescott shared a Nobel with Finn Kydland of
Carnegie Mellon University.

Meanwhile, saltwater economists balked. Where the freshwater
economists were purists, saltwater economists were pragmatists. While
economists like N. Gregory Mankiw at Harvard, Olivier Blanchard at
M.I.T. and David Romer at the University of California, Berkeley,
acknowledged that it was hard to reconcile a Keynesian demand-side
view of recessions with neoclassical theory, they found the evidence
that recessions are, in fact, demand-driven too compelling to reject.
So they were willing to deviate from the assumption of perfect markets
or perfect rationality, or both, adding enough imperfections to
accommodate a more or less Keynesian view of recessions. And in the
saltwater view, active policy to fight recessions remained desirable.

But the self-described New Keynesian economists weren’t immune to the
charms of rational individuals and perfect markets. They tried to keep
their deviations from neoclassical orthodoxy as limited as possible.
This meant that there was no room in the prevailing models for such
things as bubbles and banking-system collapse. The fact that such
things continued to happen in the real world — there was a terrible
financial and macroeconomic crisis in much of Asia in 1997-8 and a
depression-level slump in Argentina in 2002 — wasn’t reflected in the
mainstream of New Keynesian thinking.

Even so, you might have thought that the differing worldviews of
freshwater and saltwater economists would have put them constantly at
loggerheads over economic policy. 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. At a 90th birthday celebration for Milton
Friedman, Ben Bernanke, formerly a more or less New Keynesian
professor at Princeton, and by then a member of the Fed’s governing
board, declared of the Great Depression: “You’re right. We did it.
We’re very sorry. But thanks to you, it won’t happen again.” The clear
message was that all you need to avoid depressions is a smarter Fed.

And as long as macroeconomic policy was left in the hands of the
maestro Greenspan, without Keynesian-type stimulus programs,
freshwater economists found little to complain about. (They didn’t
believe that monetary policy did any good, but they didn’t believe it
did any harm, either.)

It would take a crisis to reveal both how little common ground there
was and how Panglossian even New Keynesian economics had become.


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. Yet key policy
makers failed to see the obvious. In 2004, Alan Greenspan dismissed
talk of a housing bubble: “a national severe price distortion,” he
declared, was “most unlikely.” Home-price increases, Ben Bernanke said
in 2005, “largely reflect strong economic fundamentals.”

How did they miss the bubble? To be fair, interest rates were
unusually low, possibly explaining part of the price rise. It may be
that Greenspan and Bernanke also wanted to celebrate the Fed’s success
in pulling the economy out of the 2001 recession; conceding that much
of that success rested on the creation of a monstrous bubble would
have placed a damper on the festivities.

But there was something else going on: a general belief that bubbles
just don’t happen. What’s striking, when you reread Greenspan’s
assurances, is that they weren’t based on evidence — they were based
on the a priori assertion that there simply can’t be a bubble in
housing. And the finance theorists were even more adamant on this
point. In a 2007 interview, Eugene Fama, the father of the
efficient-market hypothesis, declared that “the word ‘bubble’ drives
me nuts,” and went on to explain why we can trust the housing market:
“Housing markets are less liquid, but people are very careful when
they buy houses. It’s typically the biggest investment they’re going
to make, so they look around very carefully and they compare prices.
The bidding process is very detailed.”

Indeed, home buyers generally do carefully compare prices — that is,
they compare the price of their potential purchase with the prices of
other houses. But this says nothing about whether the overall price of
houses is justified. It’s ketchup economics, again: because a
two-quart bottle of ketchup costs twice as much as a one-quart bottle,
finance theorists declare that the price of ketchup must be right.

In short, the belief in efficient financial markets blinded many if
not most economists to the emergence of the biggest financial bubble
in history. And efficient-market theory also played a significant role
in inflating that bubble in the first place.

Now that the undiagnosed bubble has burst, the true riskiness of
supposedly safe assets has been revealed and the financial system has
demonstrated its fragility. U.S. households have seen $13 trillion in
wealth evaporate. More than six million jobs have been lost, and the
unemployment rate appears headed for its highest level since 1940. So
what guidance does modern economics have to offer in our current
predicament? And should we trust it?


Between 1985 and 2007 a false peace settled over the field of
macroeconomics. There hadn’t been any real convergence of views
between the saltwater and freshwater factions. But these were the
years of the Great Moderation — an extended period during which
inflation was subdued and recessions were relatively mild. Saltwater
economists believed that the Federal Reserve had everything under
control. Fresh­water economists didn’t think the Fed’s actions were
actually beneficial, but they were willing to let matters lie.

But the crisis ended the phony peace. Suddenly the narrow,
technocratic policies both sides were willing to accept were no longer
sufficient — and the need for a broader policy response brought the
old conflicts out into the open, fiercer than ever.

Why weren’t those narrow, technocratic policies sufficient? The
answer, in a word, is zero.

During a normal recession, the Fed responds by buying Treasury bills —
short-term government debt — from banks. This drives interest rates on
government debt down; investors seeking a higher rate of return move
into other assets, driving other interest rates down as well; and
normally these lower interest rates eventually lead to an economic
bounceback. The Fed dealt with the recession that began in 1990 by
driving short-term interest rates from 9 percent down to 3 percent. It
dealt with the recession that began in 2001 by driving rates from 6.5
percent to 1 percent. And it tried to deal with the current recession
by driving rates down from 5.25 percent to zero.

But zero, it turned out, isn’t low enough to end this recession. And
the Fed can’t push rates below zero, since at near-zero rates
investors simply hoard cash rather than lending it out. So by late
2008, with interest rates basically at what macroeconomists call the
“zero lower bound” even as the recession continued to deepen,
conventional monetary policy had lost all traction.

Now what? This is the second time America has been up against the zero
lower bound, the previous occasion being the Great Depression. And it
was precisely the observation that there’s a lower bound to interest
rates that led Keynes to advocate higher government spending: when
monetary policy is ineffective and the private sector can’t be
persuaded to spend more, the public sector must take its place in
supporting the economy. Fiscal stimulus is the Keynesian answer to the
kind of depression-type economic situation we’re currently in.

Such Keynesian thinking underlies the Obama administration’s economic
policies — and the freshwater economists are furious. For 25 or so
years they tolerated the Fed’s efforts to manage the economy, but a
full-blown Keynesian resurgence was something entirely different. Back
in 1980, Lucas, of the University of Chicago, wrote that Keynesian
economics was so ludicrous that “at research seminars, people don’t
take Keynesian theorizing seriously anymore; the audience starts to
whisper and giggle to one another.” Admitting that Keynes was largely
right, after all, would be too humiliating a comedown.

And so Chicago’s Cochrane, outraged at the idea that government
spending could mitigate the latest recession, declared: “It’s not part
of what anybody has taught graduate students since the 1960s.
They are fairy tales that have been proved false. It is
very comforting in times of stress to go back to the fairy tales we
heard as children, but it doesn’t make them less false.” (It’s a mark
of how deep the division between saltwater and freshwater runs that
Cochrane doesn’t believe that “anybody” teaches ideas that are, in
fact, taught in places like Princeton, M.I.T. and Harvard.)

Meanwhile, saltwater economists, who had comforted themselves with the
belief that the great divide in macroeconomics was narrowing, were
shocked to realize that freshwater economists hadn’t been listening at
all. Freshwater economists who inveighed against the stimulus didn’t
sound like scholars who had weighed Keynesian arguments and found them
wanting. Rather, they sounded like people who had no idea what
Keynesian economics was about, who were resurrecting pre-1930
fallacies in the belief that they were saying something new and

And it wasn’t just Keynes whose ideas seemed to have been forgotten.
As Brad DeLong of the University of California, Berkeley, has pointed
out in his laments about the Chicago school’s “intellectual collapse,”
the school’s current stance amounts to a wholesale rejection of Milton
Friedman’s ideas, as well. Friedman believed that Fed policy rather
than changes in government spending should be used to stabilize the
economy, but he never asserted that an increase in government spending
cannot, under any circumstances, increase employment. In fact,
rereading Friedman’s 1970 summary of his ideas, “A Theoretical
Framework for Monetary Analysis,” what’s striking is how Keynesian it

And Friedman certainly never bought into the idea that mass
unemployment represents a voluntary reduction in work effort or the
idea that recessions are actually good for the economy. Yet the
current generation of freshwater economists has been making both
arguments. Thus Chicago’s Casey Mulligan suggests that unemployment is
so high because many workers are choosing not to take jobs: “Employees
face financial incentives that encourage them not to work . . .
decreased employment is explained more by reductions in the supply of
labor (the willingness of people to work) and less by the demand for
labor (the number of workers that employers need to hire).” Mulligan
has suggested, in particular, that workers are choosing to remain
unemployed because that improves their odds of receiving mortgage
relief. And Cochrane declares that high unemployment is actually
good: “We should have a recession. People who spend their lives
pounding nails in Nevada need something else to do.”

Personally, I think this is crazy. Why should it take mass
unemployment across the whole nation to get carpenters to move out of
Nevada? Can anyone seriously claim that we’ve lost 6.7 million jobs
because fewer Americans want to work? But it was inevitable that
freshwater economists would find themselves trapped in this
cul-de-sac: if you start from the assumption that people are perfectly
rational and markets are perfectly efficient, you have to conclude
that unemployment is voluntary and recessions are desirable.

Yet if the crisis has pushed freshwater economists into absurdity, it
has also created a lot of soul-searching among saltwater economists.
Their framework, unlike that of the Chicago School, both allows for
the possibility of involuntary unemployment and considers it a bad
thing. But the New Keynesian models that have come to dominate
teaching and research assume that people are perfectly rational and
financial markets are perfectly efficient. To get anything like the
current slump into their models, New Keynesians are forced to
introduce some kind of fudge factor that for reasons unspecified
temporarily depresses private spending. (I’ve done exactly that in
some of my own work.) And if the analysis of where we are now rests on
this fudge factor, how much confidence can we have in the models’
predictions about where we are going?

The state of macro, in short, is not good. So where does the
profession go from here?


Economics, as a field, got in trouble because economists were seduced
by the vision of a perfect, frictionless market system. If the
profession is to redeem itself, it will have to reconcile itself to a
less alluring vision — that of a market economy that has many virtues
but that is also shot through with flaws and frictions. The good news
is that we don’t have to start from scratch. Even during the heyday of
perfect-market economics, there was a lot of work done on the ways in
which the real economy deviated from the theoretical ideal. What’s
probably going to happen now — in fact, it’s already happening — is
that flaws-and-frictions economics will move from the periphery of
economic analysis to its center.

There’s already a fairly well developed example of the kind of
economics I have in mind: the school of thought known as behavioral
finance. Practitioners of this approach emphasize two things. First,
many real-world investors bear little resemblance to the cool
calculators of efficient-market theory: they’re all too subject to
herd behavior, to bouts of irrational exuberance and unwarranted
panic. Second, even those who try to base their decisions on cool
calculation often find that they can’t, that problems of trust,
credibility and limited collateral force them to run with the herd.

On the first point: even during the heyday of the efficient-market
hypothesis, it seemed obvious that many real-world investors aren’t as
rational as the prevailing models assumed. Larry Summers once began a
paper on finance by declaring: “THERE ARE IDIOTS. Look around.” But
what kind of idiots (the preferred term in the academic literature,
actually, is “noise traders”) are we talking about? Behavioral
finance, drawing on the broader movement known as behavioral
economics, tries to answer that question by relating the apparent
irrationality of investors to known biases in human cognition, like
the tendency to care more about small losses than small gains or the
tendency to extrapolate too readily from small samples (e.g., assuming
that because home prices rose in the past few years, they’ll keep on

Until the crisis, efficient-market advocates like Eugene Fama
dismissed the evidence produced on behalf of behavioral finance as a
collection of “curiosity items” of no real importance. That’s a much
harder position to maintain now that the collapse of a vast bubble — a
bubble correctly diagnosed by behavioral economists like Robert
Shiller of Yale, who related it to past episodes of “irrational
exuberance” — has brought the world economy to its knees.

On the second point: suppose that there are, indeed, idiots. How much
do they matter? Not much, argued Milton Friedman in an influential
1953 paper: smart investors will make money by buying when the idiots
sell and selling when they buy and will stabilize markets in the
process. But the second strand of behavioral finance says that
Friedman was wrong, that financial markets are sometimes highly
unstable, and right now that view seems hard to reject.

Probably the most influential paper in this vein was a 1997
publication by Andrei Shleifer of Harvard and Robert Vishny of
Chicago, which amounted to a formalization of the old line that “the
market can stay irrational longer than you can stay solvent.” As they
pointed out, arbitrageurs — the people who are supposed to buy low and
sell high — need capital to do their jobs. And a severe plunge in
asset prices, even if it makes no sense in terms of fundamentals,
tends to deplete that capital. As a result, the smart money is forced
out of the market, and prices may go into a downward spiral.

The spread of the current financial crisis seemed almost like an
object lesson in the perils of financial instability. And the general
ideas underlying models of financial instability have proved highly
relevant to economic policy: a focus on the depleted capital of
financial institutions helped guide policy actions taken after the
fall of Lehman, and it looks (cross your fingers) as if these actions
successfully headed off an even bigger financial collapse.

Meanwhile, what about macroeconomics? Recent events have pretty
decisively refuted the idea that recessions are an optimal response to
fluctuations in the rate of technological progress; a more or less
Keynesian view is the only plausible game in town. Yet standard New
Keynesian models left no room for a crisis like the one we’re having,
because those models generally accepted the efficient-market view of
the financial sector.

There were some exceptions. One line of work, pioneered by none other
than Ben Bernanke working with Mark Gertler of New York University,
emphasized the way the lack of sufficient collateral can hinder the
ability of businesses to raise funds and pursue investment
opportunities. A related line of work, largely established by my
Princeton colleague Nobuhiro Kiyotaki and John Moore of the London
School of Economics, argued that prices of assets such as real estate
can suffer self-reinforcing plunges that in turn depress the economy
as a whole. But until now the impact of dysfunctional finance hasn’t
been at the core even of Keynesian economics. Clearly, that has to


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.

Paul Krugman is a Times columnist and winner of the 2008 Nobel
Memorial Prize in Economic Science. His latest book is “The Return of
Depression Economics and the Crisis of 2008.”

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