The reason economists failed to predict the current downturn, according to Krugman, is because their models concentrate on the interactions of rational participants in perfect markets, largely ignoring human psychology and deviations from idealized models. Furthermore, Krugman claims that economists became fixated on creating "beautiful" mathematics for the sake of mathematics (remember Dirac?).
Brief history of economic thought
First, for those of us who haven't taken a course in economics for a few years, Krugman reminds how the science of macroeconomics developed since the birth of the field:
- In 1776 Adam Smith publishes his landmark book The Birth of Nations, in which he introduces a free and perfectly efficient market that guides economic development by an invisible hand.
- By early twentieth century, Smith's view is refined with the addition of externalities that disturb the perfectly efficient market model, in what became known as a neoclassical model of macroeconomics. However, in this view the market still rules supreme and requires no regulation from the state.
- After the Great Depression, John Keynes publishes The General Theory of Employment, Interest, and Money, in which he argues that private sector sometimes leads to inefficient outcomes and requires active policy responses from the state to stabilize perturbations from the business cycles. Financial markets, in particular, are labeled by Keynes as "casinos" driven by the raw emotions of its participants.
- In the second half of the twentieth century, Milton Friedman leads a broad reversion to neoclassical ideas. He advocates monetarism - limited intervention by the government that only needs to keep monetary supply consistently growing to prevent recessions.
The two camps of economics
Keynes considered financial markets a casino largely driven by emotions of the participants. But post-60's economists geared towards efficient markets (Fama), and this became a dominant thought in economics. Even 1987 market crash (still unexplained) didn't raise enough eyebrows. This culminated with CAPM, which assigns values to portfolios of equities, bonds, and derivatives assuming that all investors rationally balance risk against reward. Greenspan, in particular, was a large supporter of financial deregulation.
Forty years ago macroeconomics divided into two camps: saltwater school (relatively Keynesian, concentrated around the coasts), and freshwater (more neo-classical, concentrated in midland universities).
Edward Prescott's and other freshwater economists' explanation for why demand-driven recessions happen in a rational and efficient market: changes in demand have nothing to do with business cycles, but are caused by fluctuation in the rate of technical progress amplified by rational response of the workers, who voluntarily decide to take time off in unfavorable economic conditions (Great Depression -> Great Vacation).
New Keynesians modified neo-classical orthodoxy to include minor additional effects, so that active policies to fight recessions could be justified. But they didn't go far enough to explain drastic effects such as Japanese real estate bubble or collapse of the Asian financial system in 1997-1998.
New-Keynesian economists are now incorporating elements from behavioral finance, which, according to Krugman, freshwater economists reject as a mere "curiosity with no real consequences" (of course, this might just be populist labeling on Krugman's part). Andrei Shleifer et al summarize this with the following line:
"the market can stay irrational longer than you can stay solvent"
Krugman presents several quotations by Greenspan and others that show that they didn't believe raising housing prices throughout 2005 constituted a bubble (since bubbles don't exist in neo-classical view under efficient market hypothesis).
How to deal with recessions
Normally, the Fed starts buying short-term Treasury debt (Treasury Bills) from banks. This drives the government rates down and investors seeking higher returns move to other assets. This in turn drives their interest rates down, which normally results in increased economic activity. Here is the history of rate reductions:
- 1990 recession: 9% to 3%
- 2001 recession: 6.5% to 1%
- 2008 recession: 5.25% to 0%
Cochrane's response
John Cochrane, one of the most prominent economists at the University Chicago, posted a rebuttal. He treats Krugman's article as a personal attack against his enemies, which now include both freshwater economists and New Keynesians.
Cochrane summarizes Krugman's article with the following points:
- Macroeconomics failed to predict the financial crisis of 2008
- Financial markets are intrinsically inefficient due to irrational investors (use behavioral economics!)
- Huge fiscal stimulus packages are beneficial, even when they are financed through trillion-dollar deficits. Krugman likes the stimulus package, and this was probably the most important point of his oped. Political reasons? (is he running for office?)
"Efficiency" in the markets does not promise stability. In fact, Cochrane says that "stable growth" would be a violation of efficiency (is he referring to fluctuations in the rate of technological progress?).
Free market is a bad system, but it is a better system than all other alternatives that involve government intervention. Freddie Mae, Fannie Mac, and Congress tried to regulate the mortgage markets - and looks where we are today. Regulators are just as irrational as the market participants.
Ricardian equivalence theorem: debt-financed spending cannot have any effect because people, seeing a higher future tax liability, will simply start saving more. But: works in China which uses non-debt based stimulus. And: what if people bank on accelerating increase in GDP growth to go around an increase in taxes.
