WORTH READING From an Economist -- How Did Economists Get It So Wrong?

[David Farber <dave () farber net>]

Begin forwarded message:

From: "Faulhaber, Gerald" <faulhabe () wharton upenn edu>
Date: September 20, 2009 1:13:48 PM EDT
To: "dave () farber net" <dave () farber net>
Subject: [IP] From an Economist -- How Did Economists Get It So Wrong?

Dave [for IP, if you wish, but long]

You may have missed this mail sent to you re: the Krugman article.  I  
would recommend it strongly.

Professor Emeritus Gerald Faulhaber
Business and Public Policy Dept.
Wharton School, University of Pennsylvania
Philadelphia, PA 19104
Professor Emeritus of Law
University of Pennsylvania


-----Original Message-----
From: Russ Nelson [mailto:nelson () crynwr com]
Sent: Sunday, September 20, 2009 3:21 AM
To: dave () farber net
Cc: Faulhaber, Gerald; Dewayne Hendricks; Newmedia () aol com; Tony  
Lauck; john.cochrane () ChicagoBooth edu
Subject: Re: [IP] From an Economist -- How Did Economists Get It So  
Wrong?

You may enjoy John Cochrane's response to Krugman's attack on him and
his profession, entitled "How Did Paul Krugman Get It So Wrong?".

Note at the end of his response, he asks that people pass around this
link as the canonical pointer to it:

http://faculty.chicagobooth.edu/john.cochrane/research/Papers/#news



              How Did Paul Krugman Get It So Wrong?

Many friends and colleagues have asked me what I think of Paul
Krugman's New York Times Magazine article, "How did Economists get it
so wrong?"

Most of all, it's sad. Imagine this weren't economics for a
moment. Imagine this were a respected scientist turned popular writer,
who says, most basically, that everything everyone has done in his
field since the mid 1960s is a complete waste of time. Everything that
fills its academic journals, is taught in its PhD programs, presented
at its conferences, summarized in its graduate textbooks, and rewarded
with the accolades a profession can bestow, including multiple Nobel
prizes, is totally wrong.  Instead, he calls for a return to the
eternal verities of a rather convoluted book written in the 1930s, as
taught to our author in his undergraduate introductory courses.  If a
scientist, he might be a global-warming skeptic, an AIDS-HIV
disbeliever, a creationist, a stalwart that maybe continents don't
move after all.

It gets worse. Krugman hints at dark conspiracies, claiming
"dissenters are marginalized." Most of the article is just a
calumnious personal attack on an ever-growing enemies list, which now
includes "new Keyenesians" such as Olivier Blanchard and Greg Mankiw.
Rather than source professional writing, he plays gotcha with
out-of-context second-hand quotes from media interviews. He makes
stuff up, boldly putting words in people's mouths that run contrary to
their written opinions.  Even this isn't enough: he adds cartoons to
try to make his "enemies" look silly, and puts them in false and
embarrassing situations.  He accuses us of adopting ideas for pay,
selling out for "sabbaticals at the Hoover institution" and fat "Wall
street paychecks." It sounds a bit paranoid.

It's annoying to the victims, but we're big boys and girls. It's a
disservice to New York Times readers. They depend on Krugman to read
real academic literature and digest it, and they get this attack
instead. And it's ineffective. Any astute reader knows that personal
attacks and innuendo mean the author has run out of ideas.

That's the biggest and saddest news of this piece: Paul Krugman has no
interesting ideas whatsoever about what caused our current financial
and economic problems, what policies might have prevented it, or what
might help us in the future, and he has no contact with people who
do. "Irrationality" and advice to spend like a drunken sailor are
pretty superficial compared to all the fascinating things economists
are writing about it these days.

How sad.

That's what I think, but I don't expect you the reader to be convinced
by my opinion or my reference to professional consensus.  Maybe he is
right. Occasionally sciences, especially social sciences, do take a
wrong turn for a decade or two. I thought Keynesian economics was such
a wrong turn. So let's take a quick look at the ideas.

Krugman's attack has two goals. First, he thinks financial markets are
"inefficient," fundamentally due to "irrational" investors, and thus
prey to excessive volatility which needs government control. Second,
he likes the huge "fiscal stimulus" provided by multi-trillion dollar
deficits.



Efficiency.

It's fun to say we didn't see the crisis coming, but the central
empirical prediction of the efficient markets hypothesis is precisely
that nobody can tell where markets are going - neither benevolent
government bureaucrats, nor crafty hedge-fund managers, nor
ivory-tower academics. This is probably the best-tested proposition in
all the social sciences. Krugman knows this, so all he can do is huff
and puff about his dislike for a theory whose central prediction is
that nobody can be a reliable soothsayer. And of course it makes no
sense whatsoever to try to discredit efficient-markets finance because
its followers didn't see the crash coming.

Krugman writes as if the volatility of stock prices alone disproves
market efficiency, and efficient marketers just ignored it all these
years. This is a canard that Paul knows better than to pass on, no
matter how rhetorically convenient. (I can overlook his mixing up the
CAPM and Black-Scholes model, but not this.)  There is nothing about
"efficiency" that promises "stability." "Stable" growth would in fact
be a major violation of efficiency.  Efficient markets did not need to
wait for "the memory of 1929 ... gradually receding," nor did we fail
to read the newspapers in 1987.  Data from the great depression has
been included in practically all the tests. In fact, the great "equity
premium puzzle" is that if efficient, stock markets don't seem risky
enough to deter more people from investing! Gene Fama's PhD thesis was
on "fat tails" in stock returns.

It is true and very well documented that asset prices move more than
reasonable expectations of future cashflows. This might be because
people are prey to bursts of irrational optimism and pessimism. It
might also be because people's willingness to take on risk varies over
time, and is lower in bad economic times.  As Gene Fama pointed out in
1970, these are observationally equivalent explanations. Unless you
are willing to elaborate your theory to the point that it can
quantitatively describe how much and when risk premiums, or waves of
"optimism" and "pessimism," can vary, you know nothing. No theory is
particularly good at that right now.

Crying "bubble" is empty unless you have an operational procedure for
identifying bubbles, distinguishing them from rationally low risk
premiums, and not crying wolf too many years in a row. Krugman rightly
praises Robert Shiller for his warnings over many years that house
prices might fall. But advice that we should listen to Shiller,
because he got the last one right, is no more useful than previous
advice from many quarters to listen to Greenspan because he got
several ones right.  Following the last mystic oracle until he gets
one wrong, then casting him to the wolves, is not a good long-term
strategy for identifying bubbles. Krugman likes Shiller because he
advocates behavioral ideas, but that's no help either. People who call
themselves behavioral have just as wide a divergence of opinion as
those who don't. Are markets irrationally exuberant or irrationally
depressed? It's hard to tell.

This difficulty is no surprise. It's the central prediction of
free-market economics, as crystallized by Hayek, that no academic,
bureaucrat or regulator will ever be able to fully explain market
price movements. Nobody knows what "fundamental" value is. If anyone
could tell what the price of tomatoes should be, let alone the price
of Microsoft stock, communism would have worked.

More deeply, the economist's job is not to "explain" market
fluctuations after the fact, to give a pleasant story on the evening
news about why markets went up or down. Markets up? "A wave of
positive sentiment." Markets went down? "Irrational pessimism." ( "The
risk premium must have increased" is just as empty.) Our ancestors
could do that.  Really, is that an improvement on "Zeus had a fight
with Apollo?" Good serious behavioral economists know this, and they
are circumspect in their explanatory claims.

But this argument takes us away from the main point. The case for free
markets never was that markets are perfect. The case for free markets
is that government control of markets, especially asset markets, has
always been much worse.

Krugman at bottom is arguing that the government should massively
intervene in financial markets, and take charge of the allocation of
capital.  He can't quite come out and say this, but he does say
"Keynes considered it a very bad idea to let such markets...dictate
important business decisions," and "finance economists believed that
we should put the capital development of the nation in the hands of
what Keynes had called a 'casino.'" Well, if markets can't be trusted
to allocate capital, we don't have to connect too many dots to imagine
who Paul has in mind.

To reach this conclusion, you need evidence, experience, or any
realistic hope that the alternative will be better. Remember, the SEC
couldn't even find Bernie Madoff when he was handed to them on a
silver platter. Think of the great job Fannie, Freddie, and Congress
did in the mortgage market.  Is this system going to regulate
Citigroup, guide financial markets to the right price, replace the
stock market, and tell our society which new products are worth
investment?  As David Wessel's excellent In Fed We Trust makes
perfectly clear, government regulators failed just as abysmally as
private investors and economists to see the storm coming. And not from
any lack of smarts.

In fact, the behavioral view gives us a new and stronger argument
against regulation and control. Regulators are just as human and
irrational as market participants.  If bankers are, in Krugman's
words, "idiots," then so must be the typical treasury secretary, fed
chairman, and regulatory staff.  They act alone or in committees,
where behavioral biases are much better documented than in market
settings. They are still easily captured by industries, and face
politically distorted incentives.

Careful behavioralists know this, and do not quickly run from "the
market got it wrong" to "the government can put it all right." Even my
most behavioral colleagues Richard Thaler and Cass Sunstein in their
book "Nudge" go only so far as a light libertarian paternalism,
suggesting good default options on our 401(k) accounts. (And even here
they're not very clear on how the Federal Nudging Agency is going to
steer clear of industry capture.) They don't even think of jumping
from irrational markets, which they believe in deeply, to Federal
control of stock and house prices and allocation of capital.

Stimulus

Most of all, Krugman likes fiscal stimulus. In this quest, he accuses
us and the rest of the economics profession of "mistaking beauty for
truth." He's not clear on what the "beauty" is that we all fell in
love with, and why one should shun it, for good reason.  The first
siren of beauty is simple logical consistency. Paul's Keynesian
economics requires that people make logically inconsistent plans to
consume more, invest more, and pay more taxes with the same
income. The second siren is plausible assumptions about how people
behave. Keynesian economics requires that the government is able to
systematically fool people again and again.  It presumes that people
don't think about the future in making decisions today. Logical
consistency and plausible foundations are indeed "beautiful" but to me
they are also basic preconditions for "truth."

In economics, stimulus spending ran aground on Robert Barro's
Ricardian equivalence theorem. This theorem says that debt-financed
spending can't have any effect because people, seeing the higher
future taxes that must pay off the debt, will simply save more. They
will buy the new government debt and leave all spending decisions
unaltered. Is this theorem true? It's a logical connection from a set
of "if" to a set of "therefore." Not even Paul can object to the
connection.

Therefore, we have to examine the "ifs." And those ifs are, as usual,
obviously not true. For example, the theorem presumes lump-sum taxes,
not proportional income taxes. Alas, when you take this into account
we are all made poorer by deficit spending, so the multiplier is most
likely negative. The theorem (like most Keynesian economics) ignores
the composition of output; but surely spending money on roads rather
than cars can affect the overall level.

Economists have spent a generation tossing and turning the Ricardian
equivalence theorem, and assessing the likely effects of fiscal
stimulus in its light, generalizing the "ifs" and figuring out the
likely "therefores."  This is exactly the right way to do things.  The
impact of Ricardian equivalence is not that this simple abstract
benchmark is literally true. The impact is that in its wake, if you
want to understand the effects of government spending, you have to
specify why it is false.  Doing so does not lead you anywhere near
old-fashioned Keynesian economics. It leads you to consider distorting
taxes, how much people care about their children, how many people
would like to borrow more to finance today's consumption and so
on. And when you find "market failures" that might justify a
multiplier, optimal-policy analysis suggests fixing the market
failures, not their exploitation by fiscal multiplier.  Most "New
Keynesian" analyses that add frictions don't produce big multipliers.

This is how real thinking about stimulus actually proceeds. Nobody
ever "asserted that an increase in government spending cannot, under
any circumstances, increase employment." This is unsupportable by any
serious review of professional writings, and Krugman knows it. (My own
are perfectly clear on lots of possibilities for an answer that is not
zero.) But thinking through this sort of thing and explaining it is
much harder than just tarring your enemies with out-of-context quotes,
ethical innuendo, or silly cartoons.

In fact, I propose that Krugman himself doesn't really believe the
Keynesian logic for that stimulus. I doubt he would follow that logic
to its inevitable conclusions. Stimulus must have some other
attraction to him.

If you believe the Keynesian argument for stimulus, you should think
Bernie Madoff is a hero. He took money from people who were saving it,
and gave it to people who most assuredly were going to spend it.  Each
dollar so transferred, in Krugman's world, generates an additional
dollar and a half of national income.  The analogy is even
closer. Madoff didn't just take money from his savers, he essentially
borrowed it from them, giving them phony accounts with promises of
great profits to come. This looks a lot like government debt.

If you believe the Keynesian argument for stimulus, you don't care how
the money is spent. All this puffery about "infrastructure,"
monitoring, wise investment, jobs "created" and so on is
pointless. Keynes thought the government should pay people to dig
ditches and fill them up.

If you believe in Keynesian stimulus, you don't even care if the
government spending money is stolen. Actually, that would be
better. Thieves have notoriously high propensities to consume.

The crash.

Krugman's article is supposedly about how the crash and recession
changed our thinking, and what economics has to say about it. The most
amazing news in the whole article is that Paul Krugman has absolutely
no idea about what caused the crash, what policies might have
prevented it, and what policies we should adopt going forward. He
seems completely unaware of the large body of work by economists who
actually do know something about the banking and financial system, and
have been thinking about it productively for a generation.

Here's all he has to say: "Irrationality" caused markets to go up and
then down. "Spending" then declined, for unclear reasons, possibly
"irrational" as well. The sum total of his policy recommendations is
for the Federal Government to spend like a drunken sailor after the
fact.

Paul, there was a financial crisis, a classic near-run on banks. The
centerpiece of our crash was not the relatively free stock or real
estate markets, it was the highly regulated commercial banks. A
generation of economists has thought really hard about these kinds of
events. Look up Diamond, Rajan, Gorton, Kashyap, Stein, and so on.
They've thought about why there is so much short term debt, why banks
run, how deposit insurance and credit guarantees help, and how they
give incentives for excessive risk taking.

If we want to think about events and policies, this seems like more
than a minor detail. The hard and central policy debate over the last
year was how to manage this financial crisis. Now it is how to set up
the incentives of banks and other financial institutions so this mess
doesn't happen again. There's lots of good and subtle economics here
that New York Times readers might like to know about. What does
Krugman have to say? Zero.

Krugman doesn't even have anything to say about the Fed.  Ben Bernanke
did a lot more last year than set the funds rate to zero and then go
off on vacation and wait for fiscal policy to do its magic. Leaving
aside the string of bailouts, the Fed started term lending to
securities dealers. Then, rather than buy treasuries in exchange for
reserves, it essentially sold treasuries in exchange for private
debt. Though the funds rate was near zero, the Fed noticed huge
commercial paper and securitized debt spreads, and intervened in those
markets. There is no "the" interest rate anymore, the Fed is
attempting to manage them all. Recently the Fed has started buying
massive quantities of mortgage-backed securities and long-term
treasury debt.

Monetary policy now has little to do with "money" vs. "bonds" with all
the latter lumped together. Monetary policy has become wide-ranging
financial policy.  Does any of this work? What are the dangers? Can
the Fed stay independent in this new role? These are the questions of
our time. What does Krugman have to say? Nothing.

Krugman is trying to say that a cabal of obvious crackpots bedazzled
all of macroeconomics with the beauty of their mathematics, to the
point of inducing policy paralysis.  Alas, that won't stick. The sad
fact is that few in Washington pay the slightest attention to modern
macroeconomic research, in particular anything with a serious
intertemporal dimension.  Paul's simple Keynesianism has dominated
policy analysis for decades and continues to do so. From the CEA to
the Fed to the OMB and CBO, everyone just adds up consumer, investment
and government "demand" to forecast output and uses simple Phillips
curves to think about inflation.  If a failure of ideas caused bad
policy, it's a simpleminded Keynesianism that failed.

The future of economics.

How should economics change? Krugman argues for three incompatible
changes.

First, he argues for a future of economics that "recognizes flaws and
frictions," and incorporates alternative assumptions about behavior,
especially towards risk-taking.  To which I say, "Hello, Paul, where
have you been for the last 30 years?" Macroeconomists have not spent
30 years admiring the eternal verities of Kydland and Prescott's 1982
paper. Pretty much all we have been doing for 30 years is introducing
flaws, frictions and new behaviors, especially new models of attitudes
to risk, and comparing the resulting models, quantitatively, to data.
The long literature on financial crises and banking which Krugman does
not mention has also been doing exactly the same.

Second, Krugman argues that "a more or less Keynesian view is the only
plausible game in town," and "Keynesian economics remains the best
framework we have for making sense of recessions and depressions." One
thing is pretty clear by now, that when economics incorporates flaws
and frictions, the result will not be to rehabilitate an 80-year-old
book. As Paul bemoans, the "new Keynesians" who did just what he asks,
putting Keynes inspired price-stickiness into logically coherent
models, ended up with something that looked a lot more like
monetarism. (Actually, though this is the consensus, my own work finds
that new-Keynesian economics ended up with something much different
and more radical than monetarism.) A science that moves forward almost
never ends up back where it started. Einstein revises Newton, but does
not send you back to Aristotle.  At best you can play the fun game of
hunting for inspirational quotes, but that doesn't mean that you could
have known the same thing by just reading Keynes once more.

Third, and most surprising, is Krugman's Luddite attack on
mathematics; "economists as a group, mistook beauty, clad in
impressive-looking mathematics, for truth." Models are "gussied up
with fancy equations." I'm old enough to remember when Krugman was
young, working out the interactions of game theory and increasing
returns in international trade for which he won the Nobel Prize, and
the old guard tut-tutted "nice recreational mathematics, but not
real-world at all." He once wrote eloquently about how only math keeps
your ideas straight in economics. How quickly time passes.

Again, what is the alternative? Does Krugman really think we can make
progress on his - and my - agenda for economic and financial research
-- understanding frictions, imperfect markets, complex human behavior,
institutional rigidities - by reverting to a literary style of
exposition, and abandoning the attempt to compare theories
quantitatively against data? Against the worldwide tide of
quantification in all fields of human endeavor (read "Moneyball") is
there any real hope that this will work in economics?

No, the problem is that we don't have enough math. Math in economics
serves to keep the logic straight, to make sure that the "then" really
does follow the "if," which it so frequently does not if you just
write prose. The challenge is how hard it is to write down explicit
artificial economies with these ingredients, actually solve them, in
order to see what makes them tick. Frictions are just bloody hard with
the mathematical tools we have now.



The insults.

The level of personal attack in this article, and fudging of the facts
to achieve it, is simply amazing.

As one little example (ok, I'm a bit sensitive), take my quotation
about carpenters in Nevada. I didn't write this. It's a quote, taken
out of context, from a bloomberg.com article, written by a reporter
who I spent about 10 hours with patiently trying to explain some
basics, and who also turned out only to be on a hunt for embarrassing
quotes.  (It's the last time I'll do that!)  I was trying to explain
how sectoral shifts contribute to unemployment. Krugman follows it by
a lie -- I never asserted that "it take mass unemployment across the
whole nation to get carpenters to move out of Nevada." You can't even
dredge up a quote for that monstrosity.

What's the point?  I don't think Paul disagrees that sectoral shifts
result in some unemployment, so the quote actually makes sense as
economics. The only point is to make me, personally, seem heartless --
a pure, personal, calumnious attack, having nothing to do with
economics.

Bob Lucas has written extensively on Keynesian and monetarist
economics, sensibly and even-handedly.  Krugman chooses to quote a
joke, made back in 1980 at a lunch talk to some business school
alumni. Really, this is on the level of the picture of Barack Obama
with Bill Ayres that Sean Hannity likes to show on Fox News.

It goes on. Krugman asserts that I and others "believe" "that an
increase in government spending cannot, under any circumstances,
increase employment," or that we "argued that price fluctuations and
shocks to demand actually had nothing to do with the business cycle."
These are just gross distortions, unsupported by any documentation,
let alone professional writing. And Krugman knows better. All economic
models are simplified to exhibit one point; we all understand the real
world is more complicated; and his job is supposed to be to explain
that to lay readers. It would be no different than if someone were to
look up Paul's early work which assumed away transport costs and claim
"Paul Krugman believes ocean shipping is free, how stupid" in the Wall
Street Journal.

The idea that any of us do what we do because we're paid off by fancy
Wall Street salaries or cushy sabbaticals at Hoover is just
ridiculous. (If Krugman knew anything about hedge funds he'd know that
believing in efficient markets disqualifies you for employment. Nobody
wants a guy who thinks you can't make any money trading!)  Given
Krugman's speaking fees, it's a surprising first stone for him to
cast.

Apparently, salacious prose, innuendo, calumny, and selective
quotation from media aren't enough: Krugman added cartoons to try to
make opponents look silly. The Lucas-Blanchard-Bernanke conspiratorial
cocktail party celebrating the end of recessions is a silly
fiction. So is their despondent gloom on reading "recession" in the
paper. Nobody at a conference looks like Dr. Pangloss with wild hair
and a suit from the 1800s. (OK, Randy Wright has the hair, but not the
suit.)  Keynes did not reappear at the NBER to be booed as an
"outsider."  Why are you allowed to make things up in pictures that
wouldn't pass even the Times' weak fact-checking in words?

Most of all, Krugman isn't doing his job.  He's supposed to read,
explain, and criticize things economists write, and real professional
writing, not interviews, opeds and blog posts. At a minimum, this
style leads to the unavoidable conclusion that Krugman isn't reading
real economics anymore.



How did Krugman get it so wrong?

So what is Krugman up to? Why become a denier, a skeptic, an apologist
for 70 year old ideas, replete with well-known logical fallacies, a
pariah? Why publish an essentially personal attack on an ever-growing
enemies list that now includes practically every professional
economist? Why publish an incoherent vision for the future of
economics?

The only explanation that makes sense to me is that Krugman isn't
trying to be an economist, he is trying to be a partisan, political
opinion writer. This is not an insult. I read George Will, Charles
Krauthnammer and Frank Rich with equal pleasure even when I disagree
with them.  Krugman wants to be Rush Limbaugh of the Left.

Alas, to Krugman, as to far too many ex-economists in partisan
debates, economics is not a quest for understanding.  It is a set of
debating points to argue for policies that one has adopted for
partisan political purposes. "Stimulus" is just marketing to sell
Congressmen and voters on a package of government spending priorities
that you want for political reasons. It's not a proposition to be
explained, understood, taken seriously to its logical limits, or
reflective of market failures that should be addressed directly.

Why argue for a nonsensical future for economics? Well, again, if you
don't regard economics as a science, a discipline that ought to result
in quantitative matches to data, a discipline that requires
crystal-clear logical connections between the "if" and the "then," if
the point of economics is merely to provide marketing and propaganda
for politically-motivated policy, then his writing does make sense. It
makes sense to appeal to some future economics - not yet worked out,
even verbally - to disdain quantification and comparison to data, and
to appeal to the authority of ancient books as interpreted you, their
lone remaining apostle.

Most of all, this is the only reason I can come up with to understand
why Krugman wants to write personal attacks on those who disagree with
him. I like it when people disagree with me, and take time to read my
work and criticize it. At worst I learn how to position it better. At
best, I discover I was wrong and learn something. I send a polite
thank you note.

Krugman wants people to swallow his arguments whole from his
authority, without demanding logic, or evidence.  Those who disagree
with him, alas, are pretty smart and have pretty good arguments if you
bother to read them. So, he tries to discredit them with personal
attacks.

This is the political sphere, not the intellectual one. Don't argue
with them, swift-boat them. Find some embarrassing quote from an old
interview. Well, good luck, Paul. Let's just not pretend this has
anything to do with economics, or actual truth about how the world
works or could be made a better place.

*University of Chicago Booth School of Business. Many colleagues and
friends helped, but I don't want to name them for obvious
reasons. Krugman fans: Please don't bother emailing me to tell me what
a jerk I am. I will update this occasionally, so please pass on the
link rather than the document,
http://faculty.chicagobooth.edu/john.cochrane/research/Papers/#news.

--
--my blog is at    http://blog.russnelson.com
Crynwr supports open source software
521 Pleasant Valley Rd. | +1 315-323-1241
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