A great read by Paul Krugman. Here is an abridged version.
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. ...
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. ...
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.” ...
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.” ...
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. ...
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. ...
This meant that there was no room in the prevailing [neoclassical] 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 ...
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.” ...
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. ...
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. ...
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. ...
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. ...
After working for nearly two decades in a variety of jobs within the capital markets, the idea that markets are everywhere and always efficient to me is utterly absurd.
