Why Economists Messed Up

The biggest thing in economics today is Paul Krugman’s “How Did Economists Get It So Wrong?” in the New York Times Magazine. If you have any interest in macroeconomic policy, you should read it.

For one thing, the illustrations by Jason Lutes are quite entertaining:


More important, though, is Paul’s evaluation of how we economists missed the 800-pound gorilla in the room. He fingers three suspects:

  • Mistaking beauty for truth. I.e., too much reliance on elegant, solvable, mathematical models in which economic players are rational and markets adjust to shocks easily. These models are a joy to play with — and provide important insights — but they miss messy truths about the actual economy.
  • Excess confidence in financial markets. He argues that widespread acceptance of the efficient markets hypothesis (the idea that asset prices incorporate all information and thus get prices “right”) left us blind to the risks of asset bubbles.
  • The limits of mainstream macroeconomics. This critique is harder to summarize, but in a nutshell he argues that (a) some economists have (incorrectly) embraced the classical view that the government can’t and shouldn’t try to moderate the business cycle and (b) the larger body of mainstream of economists have (correctly) embraced the Keynesian view that the government can try to moderate the business cycle but have (incorrectly) concluded that the Federal Reserve is the only appropriate tool to do so.

I think each of these charges has merit, with one caveat. Back in graduate school, I was indeed taught that monetary policy was the preferred tool for addressing economic weakness (e.g., because of policy lags and concerns about the political economy of what passes as fiscal stimulus from the Congress). In my years in Washington, however, I have met many economists, of the left, right, and center, who believe in fiscal policy as well. Indeed, in policy circles, the idea of fiscal stimulus was active in 2001, 2003, 2008, and 2009, each of which witnessed tax cuts (and, in the most recent case, spending increases) that were partly or wholly passed in the name of stimulus. One can debate the merits of those acts, but the concept of fiscal stimulus has been alive and kicking.

Paul’s recommendations for the way forward for economists:

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.

On his final point, I should note that one of the leading thinkers on the links between finance and macro is none other than Ben Bernanke, current (and, one hopes, future) chairman of the Federal Reserve. That’s one of the reasons he’s the right person for the job.

Related commentary: EconomistMom, Barry Ritholz, Paul Kedrosky, Brad DeLong, and Paul Krugman himself.

10 thoughts on “Why Economists Messed Up”

  1. Donald,

    Re: In my years in Washington, however, I have met many economists, of the left, right, and center, who believe in fiscal policy as well

    A couple of questions, just for clarification.

    1) It is one thing for one to say that monetary policy is the much-preferred tool for fighting recessions (vs. fiscal policy) until it runs out of ammunition or at least its conventional ammunition (by reaching the zero lower bound or whatever), after which fiscal policy is sometimes better than nothing (or better than less conventional Fed action), and quite another to say that fiscal policy is generally on a somewhat equal footing with monetary policy in terms of desirability for fighting recessions. Which were those economists asserting, and what is your view?

    2) Are you referring primarily to economists involved in some way with fiscal policy and who therefore may have had some bias toward it in the sense of someone whose only tool is a hammer seeing more things as nails?


    1. Hi Brooks —

      A combination of factors:

      1. Fiscal policy works in the models that the macro folks use in DC (e.g., the Macroadvisers model or the Fed model). So when higher ups ask, the professional analysts often (not always) come back with results that suggest fiscal policy could be helpful.

      2. As a guess (I haven’t thought about this thoroughly), I think the two “jobless recoveries” made some economists more sympathetic to fiscal stimulus since it weakened the argument about policy lags. Or, put another way, it made the lags seem less important.

      3. Stepping slightly away from purely objective rationales: The culture in much of Washington is that elected leaders need to take action … to do something. Elected leaders can’t control monetary policy (I hope), so they look to fiscal policy. As a result, the economists who advise them have, I think, become more accustomed to the idea of doing something.

      4. Getting even further away from objective rationales: Many DC economists have particular policies they favor, which are difficult to get enacted. Some of these policies can be characterized as stimulus, however, so the economists use concern about the macroeconomy as a way to pursue this more microeconomic objectives. On the right, the classic example is reductions in tax rates on capital (e.g., the claim that cutting the capital gains tax rate is stimulative). On the left, the classic example is extending unemployment benefits (e.g., the claim that it puts money in the pockets of people likely to spend it).

      P.S. I edited your comment to eliminate the format glitch.

      1. Thanks, Donald.

        Re: your #3, that’s essentially what I was speaking of with my “hammer” analogy (in fact, the first analogy/expression I thought of using was “Just don’t stand there; do something”)

        Re: my first question, another way of asking it is if the economists to whom you refer are saying merely that monetary policy alone is sometimes insufficient to combat a recession and should be accompanied by fiscal policy or if they are saying that fiscal policy (either alone or in conjunction with monetary policy) is optimal and preferable to greater use of monetary policy without fiscal policy even when there is room for further conventional monetary policy (i.e., interest rates could be brought down — or brought down further — without approaching the zero lower bound). Sounds like your answer is the latter, that many of these economists see fiscal policy as at least part of an optimal approach even if monetary policy could go significantly further.

        On the lags, it did seem that the rebates last year, for whatever they were worth, went from concept through execution faster than (I think) generally occurs with recession-fighting fiscal policy, but the same obviously cannot be said for the larger stimulus package underway now. As for “jobless recoveries”, if the point regarding recent/current recessions is that they are lasting longer and thus speed of implementation and effect becomes less important (and thus the lag drawback less significant), I suppose that’s true, although I wonder about the reliability of forecasting duration of recessions and I’d have to wonder if a faster-acting stimulus would tend to shorten the recession (vs. stimulus with more lag) anyway. Alternatively, if the point re: “jobless recovery” doesn’t really concern timing but relates to some “new normal” of higher unemployment after the recession, using fiscal policy to try to alter that new equilibrium would seem to require some argument of a different nature than one involving efficacy of fiscal policy (vs. monetary or in general) in fighting recessions.

        By the way, an idea that occurred to me in January 2008 for fiscal stimulus* is government-issued gift certificates with a short expiration date. Like increased transfer payments (e.g., increased food stamps), they would achieve the objective of being mostly spent rather than saved, but unlike those transfer payments, the gift certificates would be sent to everyone so that there would not be as much “unfair” redistribution of income. Because money is fungible, to avoid people using them, in effect, to save more rather than spend more, necessities such as groceries would have to be excluded, which would seem cold and would probably cause political resistance from some on the left, but that would be netted out by the greater broad-based political support. Obviously there would need to be a one-time setup of administration for the program, and the cost of fulfillment, which would probably be a small percentage of the cost of the program.

        * Taiwan actually used this approach — “shopping vouchers” — one year later in January 2009 http://www.forbes.com/feeds/afx/2009/01/18/afx5936225.html — I don’t know “results” but I’d be interested if anyone has link to any analysis.

        p.s. Thanks for that format correction.

      2. Just as follow-up to my “gift certificate” idea, to the extent that “we” (the American people through the political process) wish to use increased transfer payments such as food stamps, unemployment benefits, etc., as stimulus in order to increase redistribution of wealth to those who suffer most during recession, we can certainly do so in lieu of my universally-distributed gift certificate idea. But the advantage of the gift certificate idea is this: even though such transfer payments are arguably the most efficient form of fiscal stimulus (faster than many forms of spending and more efficient in terms of portion immediately spent than tax rebates across broader/all income levels), there is a political limit to how much such redistributional (transfer payment) stimulus can get through Congress, and the result is that we get some amount of it accompanied by less efficient forms of stimulus such as “middle class” rebates to placate that “middle class”. Rather than the latter, the gift certificates would accomplish the efficiency (getting spent rather than saved) without the political limitation faced by redistributional transfer payments.

  2. Those same points were made at least a dozen times over the last few years by many economists. Why the fuss over Krugman’s indictment/not-me-a culpa?

  3. Please have a look at ‘Stefan Karlsson’s Blog’ in which Paul Krugman was severely criticized for his approach towards Economic Crisis. It was revealed that Paul Krugman has himself suggested housing bubble to get rid of dotcom bubble, thus being so unsympathetic to after-effects that would cause to common citizens. I’m interested in your reaction after seeing that article and also it’s links to Krug’s actual writings.

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