Tuesday, September 15, 2009

How Do Economists Continue to Get it So Wrong?

I linked to Krugman's NYT article "How Did Economists Get it So Wrong?" with the comment, "Why I don't believe in Macro." The article has of course caused quite a stir, and I thought that I would clarify my position a bit: (macro)economists have always gotten it wrong, and continue to get it wrong.

Part of the reason I don't believe in macro is the way that many essentially valid (if limited) insights are put in a blender, mashed together and poured into the leaky economics 101-level understanding of the media. Nevertheless, I will now make some of the same types of baseless generalizations and ridiculous caricatures for your enjoyment (?).

Neither Keynesians nor Free Marketers have it right.

Free markers are right to attack as patently absurd the idea that government technocrats can set this ephemeral thing called "aggregate demand" to whatever level they please using fiscal stimulus. But you don't need to believe in the fiscal multiplier -- the amount of money $1 of government spending generates -- to think that the stimulus package was necessary to restore confidence in the economy. What we needed was a sign that Democrats and Republican (or at least Democrats) would be able to get their acts together and pass some aggressive legislation if they really needed to, which they did.

Keynesians are equally right to attack as patently absurd the idea that the efficient market hypothesis -- the idea that prices are always our best guess given the available information -- makes regulation unnecessary. In Chicago economist John Cochrane's response to Krugman, he writes, "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." This argument takes us away from the main point: the government has always, and will always, set the rules of the game in markets. And right now, we need some better rules.

The financial crisis happened because everyone got it wrong. Bankers, regulators, mortgage brokers, home buyers, economists -- everyone. In response, everyone needs to look at what they did wrong and how they can do better, not start flame wars in the New York Times magazine pointing fingers. Economists can help make better rules and more effective government spending by focusing on the microeconomics of the institutional, collective action, and behavioral fields. At this point, economics is such a young and naive science that "general equilibrium" -- the attempt to model everything -- is a purely academic exercise with less practical relevancy than attempts to model the movements of ants in anthills. Let's take our best shot at figuring out what's wrong the with regulations we have, and see if we can't do a little better. Of course technocrats aren't any smarter than bankers and the new regulations might make things even worse; that's why we should test our theories using experiments. If things get screwed up anyway, we can always challenge the new rules under the "just and reasonable" standard of common law.

Maybe one day I'll believe in macro, but right now I say focus on the nerdy specifics of microeconomics and leave the macroeconomy to its "animal spirits."


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