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 efforts.
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.
II. FROM SMITH TO KEYNES AND BACK
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
good.
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 right.
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.
III. PANGLOSSIAN FINANCE
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, but 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 efficient.
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.
IV. THE TROUBLE WITH MACRO
“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.
V. NOBODY COULD HAVE PREDICTED . . .
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?
VI. THE STIMULUS SQUABBLE
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 [Keynesian ideas] 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 profound.
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 seems.
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?
VII. FLAWS AND FRICTIONS
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 rising).
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 change.
VIII. RE-EMBRACING KEYNES
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 Op-Ed 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.”
