How Did E(ol\OIrio.;t~ Get It SI..) \\ IllIg', - ;'JY-r i"C~I.:\) ~.

Septemher 6, 200

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How Did E·cononlists Get It So Wrong?

1. MISTAKI~G BEAlTry FOR TRF1"t[

It's hard to believe OOW, tut not long ago economists wt.re congratuiating themselves O\'er the ~u':cess of

their field. Those sucu::sses - tlr so 1.h\;;; belie'cd - VI ere botli theoretical and practical, le3ding to a golden

era for the professi']:1 On t'i( the()n:,'j~al side. they thought t:-_at the~ had resch'ed their internal disputes.

Thus, ir. a :moS p<.tp(-~·titlcll"Tbt' SLtte of ManD" (that is, mJ.cro~cono:nics, tl1e study of big-picture issues

like reces;j 'n,;\ .)1\ .ff ~1;"1,,11 i 'f! ,f ','f - T.. 1'1\', til"' ch ;ec l'l'f n, l:-nl:-t at the Lltern1tional Monet;;rv Fund,

declared thJt "the state of J:1Jcr::: is go\.d." The battles of yesLry"ear, he said, were over, and there had been

a "broad convergelicc ai' \ision."' And in the real world, economists believed lhey had things under control:

the "central problem cf d'~Drcs,':Jr-rre\·entio!1 has been solved." declared Robert Lucas of the University of

Chic4@ in his 200:~pre~idcntiJI addres~ to the .-\.r..1Crican Eco:-lomic Association, In 2004. Ben Bernanke, a

former Princeton p,ofessor '.·.h,) i,,,: I~O',V thl:.' c;l~:irrnan of the ~h.d..;rall:~ese[Te Eoard, cel~brated th~ Great

Moderation in eec Il )uic pert'oc'm,;1":c ()\ e, J1<2 pre',ii)US [',\"0 decades. \"'!lich he Jttributed in P3rt to

improved tCor:or:jc l'nliCy .!;,.lk:n'~.

Few economists -;aw our current crisis ..:orning, but this tJfed;ctive bilure was the least of the field's

problems. More il:1pOl't.lDt wa:> the profession's hlindness ~o the n;ry possibilit::i of catastrophic failures in a

market economy. During the golden "cars. financial ecooomi.ots came to believe that markets were

inherently ,table - indeed. th:1: stQck~ und ocbc a:-=sets were always priced just right. There was nOlhing in

the prevailing: mod'2b "'ugg~st-ing the pnssibilit:. or t;-,2 b1d of ,~:)lI;j~se that nappcned last ye2.r. Meanwhile,

macrccconomist:; 'd~fC dlvic,'c! in th,~il ..ie·As. But t!k m:::in rj''':sien W~1~between those who insisted that

free-market CCOJ:.OT i!~:,t1L"l"~, 'W a~t·'J:'- ;jnJ th,)sc: ;,\f:,10 beli,:~\ .;d ~hat eeonomies may stray now and then but

that :my t"IJ,jnr d ·!':·II;·)r:~ ~,.•, 'C l-:,,; -1"!1 :Jf pL,'-ir,:::=-i~, cculJ 'nJ "'o',:J te corrected by the all-powerful

fed . .'IIeithl'i ;"iJ , '\ ;],' I)rcp<·~·,,:(~k' C\'y': ,~·ith<.1:: >;('( [".I}elY tb~ \'.... It liff the rails despit~ the Fed's best

effort~.

And ir; the W~!ktc: ()c the cri"::lS. t)- ral.!: lires:n th: ~cl)n.)njr:, rrok:-:s;\)O ba\·e yuwned \-,'ider th:m e\-er.

Lucas s;;ys ['1, 0h.l "11:' 'ld m:ni,,::l-·:.lLn ~.~ .;-:im d..:s pIa 1:-: af·~ "-;( !,'rc:,: e\:onof:1ics.'· anJ hi," Chicago colleague

.John Cf)c~r;:_lt:' ":;j:'~ Ih..;y're b~;cJ 'I' jls.:r:;>,j "I,e"f. i~;"lh~::," [r -[,o"'p'JI1S2. Br:.:c. Dd_o'.1'~ of the ~ni\'C'rsit\" of

CalibrJ1i~l, Ss:-j, :ic:: ',rit::::. l:i' !-<-; ""t :k~!.['Jal,l)'j;][)"e" J t'"'I~\=:1:C;1';:j Schoo;, an(~ I myself luve written

that c.m::lll~n ts fr'~n; i "1 :" HI ) v:ji-<.tr i~ts :J.rc rh ; 'Jrnc!u,t (If;:: D:.l-k .-'<!r:=of m:2''fceeocomics in which

A-2-5

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impressiw-lookin;s m'ith,~nnti{>. for tnith. l'ntil t!L: Gre'!l.P~ill:::.-;sioJ1. most econon:ists clung to a \ision ofcapitalism as a pen'cl't or ne,Jr!y perfect systerr .. That \i)jon wasn't sustJin:tble in the face of massunemployment, but a,~meli1orie<; (If th2 Depres::;ion LJded. economists fell back in lo\'e with the old,idealized \ision of ,1.1 eu'n(n'~ in \,'[ il'h rat:or,:ll ind:\idtials :lltE'ra::-t in perfect tmrkets. this time gussiedup with fancy equation,.." Th n:!1-.:\,t.:! n:m:d1Cl~ \,:itl: the ide;Jlized r:'.'lrket wa:>, to be sure, partly a responseto shifting political '\'md~, rar~;:, ,.,-,- -r-cnse to r;na,,-~i:;,l in':'~':1:i\'i;';;. :;u, \\'l1ile s<:bbatic:lls at the HoowrInstitution and ,iob ~)P:)Oltu ni;.il ~ O:l WClI! StreEct .J.re nothing tn sn~eLC ut, the ce:1tral cause of theprofession's failure V:tiS the cc:s:re flir an ;JjJ--2nc\}LlIpa~:sin;, in~,:lkctll:l]Y e~egant approach that also ga\"eeconomi~t:; a chan2c ~nSf,OW o~'itheir ;;lathen:atical urO\lie~s_

Unfortunately, this romanticiz2J and <-;anitized \ isicn of the economy led most economists to ignore all thethings that C:1ngo wrl1n~. They turned a blind eye t,) the limitations of human ration;llity that often lead tobubbles and busts; t ' th~ pr"i'lc r.l ; ( f in~titll :inl1S that r.ln an'o~,; to ele imperfectl()llS of markets -especially financi'J' 1':'lrkt_t~ - tl)<Jt" In call~e t'1E-P,:(II-,om:;'s C[)e:':ltjn~ ~ystem to u~der~(o sudden,unpredictable cra,h"-; <'r:d t,- the' (_1.1n'!2rS c·l':",,:..! ,,.i\·'fO'P' rL~llL1tNs '!Ol1't believe in regulation.

It's much harder ~()S"" \1 here t 1..; Cl" 'l1omics p:-Of2S.-;iD!1goes ;'f(Jt' 1 her.:. But 'Nbat's alrilost certain is thateconomists will ha',e to 12:11"1""<t( h\'t: 'with messiness. That is, tll-=Ywiil huse to <Jcknowledge the importanceof irrational and (Ael} i.lnprui ictJbL.' Geha\;ior, tace up to the ofk;-, idiosYllcrutc imperfections of marketsand accept that an e1l':sant CCO!1')olil.' "tlwory of evcryth:.r.g" is;} hn~ \\ ay off. In practical terms, this willtranslate iiltQ more c11ltinu;; j-o'icy ;::r!\'ice - al~d a redu'2ed willingness to dism:lOtle economic safeguards inthe faith that l11;Jrkcto.: ,,·:ilI snln~ a]1 ri"(:I)I(~ms

11. FROyl SMITH TO KEl:~';F:' t'0F! r~.-'.CK

The birt~ 0f ccrn: Jl:' ~';l~ L ,~ ,;;.'i:JI: 01, :,~ clt'U:,dv C"eC:!~E:d to ;,C;J!1".S'11::h. ',,'be pubiish.::c ''The WC:1ith ofatioll:::" in 1776,0\".21 t!lt.: c;l:'(t 1 1lJ ~ 2:1rs <l11EJ,ten::i\',: :;ody 0,: (c: ,n :mic thee ry h'<lS de\"e:cped, whose

ceotral nl\.::::~J.~.;e\\ as' l"ru.;t til.,' '!l,it'kc'l Yes. c(:(~not1:ist:: ,1(:r:1lttE:d I±.;j~ there wert' C:lses in which marketsmight f:.JiLof whid the !TIost in;pu,·t,ll1t W:.JSthe '.:a.-.;,:of "cxter'lalitie:;" - costs that people impose on otherswithout p;J:;ing the prlce.like tnific congestion or pollution. Bd the basic pre~umotion of "neoclassical"'economics (r.am~J :.1:'1:<..r tr.,.: )at'2-19tJ~-('entur:- tht':or::,;ts "vila l!;}()Oi"<.J.tuJ ,)11 dlt: conct.:pts of tlleir "dassical"'predeces,-;ors') v\:'::- lil.lt w· ::h'llJiJ I:~:\'C L- it': ~I;rhe: ll'arkd ;;Y~;'l~n;,

ecor.(~n~isb i:l<-;::::'~: I' ,11',\'\',lk T:; ;,')('CS ;\1 ,1 rl"J[ ,..t ,~l')T:l]::' '11", t ').~ r;.~ht: ·'r:e)r.~ssions ;)re nDt simplyevils." cccb-:.:d I•.. ,,;: '6;', -'i"'~i' !!, ',)').:. - ~':' ..:~Tll"': ..11",1-.' 'Jcc:,.l 't,-Jl'l11:-;of SI):l1et::ing which has tobe JOlle," ~ut IL," :1 1l' ." x" ..:1" ': ):-t. ~CC'l' ::1;i~t.-t';;"!"l;C t , t",- .-_~~ £:-Jt..s~f ,19h 1.\!.i\Tlcc1l'!tKs'\11eS forboth an expIJn:lti( 'J ·,r\',·'I'~;1tro;l:! h,l;'l_r~~d <.:i::J ;l.,o;uti ),1:0 ,'t t',-".~ 11t.::[J:";:ssions.

Keyne" did not. cC':-;pil2 wh~ _'I:ll 111;,', bY(: hurd. \. :.:nt the :~' "·.r:,:~·, nt to rU'1 the economy. He describedhis analysi,,; i:- hio., I:::\'- 111,I:-l1,·.iT.r' ... "T'k (;en,: [""1 1~'h~,)['" of Em,i'''.', 1"1-=nt,interl::st ;Jnd ~yloney." as"m()Jcr;Jtel~ COI1:--t.:";'!:\'C ill it.; ;'1-~+': ',i'Jn~-." :,~,~\\anred to; t:, '~;lDit:;':sm. nol repbce it. Gut he didchaller~:!e .t-<, !1( :if ; ch,it;'-- _ .. ~1·1 'In( ,,' '''-'::;." j"_,;ct:u - ",·till). ~ : mind 'r ..:'<!,rr-::s,o:n!!;particularcOl1tem,)t h: fi,-', P~'\l";'··

reI!;]rd '-(:, ~"tl!X\l ;':

, ',·,'i.:'\ ;,,1 :,:-: ".:i~:: ~,,'-'i:-_'r; i:' ..;!;,1!;-Lr:·l',OecL:.btio'1 v\-ith little,~d"'~)r..:c ~~..1 1)\ ...:~::- ~ ~- t- :., .;", I-~n "in;~ - n-i:1 ::.C1'2~ :"'Y1""e r:~O!1eyand. if

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It's important to ur:cL:rsLJr:d Lh•.L :<.cyncs did much :110[1;: thar make bJld assertion;:;. "The General Theory"is a ",'ork of profcuml. de·:p <".njly,~is- amlysis thJt pers!~aded f1e best yO'Jng econolT,ists of the day. Yetthe story of eco!1om:c:,; 0\ er tl~ p,-::-t h'llf centul) is, tc a larg:; d~gree, the story of <Jre~reat fromKeynesianism and <:. fetl! rn tc n-:')C~<..,).~ici5::1.The rl2ocbssica~ ,e',i'.-a' ',~'asinitially led by :Y!ilton Friedmanof the University of Chicago, wr.o ::ls~e,ted as earl:. DS 195:3 that neoclassical economics works well enoughas a description of t:,~way l.b.~ lconl,my actuo.lly function3 to I:-e "horh otTernely fru:tful and deser.ing ofmuch confidence," Rut '~'h2t "bout dcores..<;ions?

Friedman's counterattJck aga in~t Keyne.:i began with the doctrine known as monetarism. Monetarists didn'tdisagree in principl( '."ith the iJea th~'" a market ecrnomy nee,.!s c'.eliberate stab:lizaticn. "We are allKeynesians 110"v:' Fri,:di11<.l:10r:ce said. alth0u:zh he bte:' chir:led he '....8S quoted out of context. Monetaristsasserted, however. f-. It a \'cr:' lir~l:t,~d, ci,rclln::(~ribed f0rm of ~;J\'"crEmell~ inten'ention - namely,instructing central b;':11,,:; til k:ep '.h' rat;on's 1~'.O!ley SLPP~Y,~he ~um ')f ca~h :n circulntion and bankdeposits, growing on 1 st"'ad) Fth _. i:::.:l1 tlla~'s ['e-::~u:red to; p:-e"ent depressions. F~~mously, Friedman andhis colbhontor, Ann·.l's::hwr't? :Jf'!"cd that if th'~ Federal Reser-H' '1.1c! chne itsj'Jh properly, the GreatDepression would n,:t ha",e h;'1'r~ncd. Tater, FrieJman l11ac!e a cnmpelling case against any deliberateeffort by government to push uncmployment bdow its ··n;.it'.U"al"level (currently thought to be about 4.8percent in the United States'l: excessi"'ely expansion<liy policies. r,e prc(I;cted, would lead to a combinationofint1atior: and h;g:. l:n.cmpl'J) ,7Ie",[ -- J prtdj~tion th:.ll was ;}IJrE,: out by the stJgt~a~if)n of the 19705,

which grc..ltly adq::LC~ t:k 'T::Jib.~j ly of th~ :':"lti-K~ynrsial1 ll1(,'."':nlen:.

Eventually, hOWE:\"LT.the JOii-l(e\ ..teS:i~l CC'Ul1k:·,·e\·o;t.:tiol1 \\':n~ far beyo:ld Friedman's position, whichcame to seem rebh lly mo,Jl:-'·[.= c('T.parEd w;tl, 't'h<.:.t hi:; Sl!':ce',scr~ v:ere s;lying. Among fin<Jl1cialecocomists, Key"lc~"~;~jio;;p,r;··j'l·!' ':-ill\~ of ~~n;1ncial market:, ,!~,] "c; :-ir;c" W<!.,~ rcpl1t:ed by "efficientmarket" theory, Iv'b'h ,1 ':-'I.:rtl.·J that f'n,1i1cia! l-.urk~t:' Qlw;~y" !:;et ;1s"et prices right given the :1vailableinformation. 1\1\',111"1 '1'[· ,"\";a,y r::icre'U~Onol1l;..;t- con-pktcly "eje~tf:d Keynes'~ fr:ll':1ework forunderst<.lnding c',.:nll( n'(, .;II,i·~1r",~"1'.1';' r'2tlrr,~C to t~e ,-i,~v' ".' SC:1l:1j)!,:ter and I)ther apologists for theGreat D(~pre:,:-,iGn, ' i':I~;I~;~,,('(":"~;i(,I1,= :':'SJ g(,od thing P'I:-t of 1''1e E'CC'101T.Y'S adjustment to change. Andeven tlnse not 'i'il::'""c;~t j 7("> tL;' f2 ' ']'"!!U2d thJ~ cPl: :Jttempt i() ~~:!h~:n c:onomic slump would do moreh:1rm tllU:l good.

Not all macroecol1<"~l::.;h w ~r;: ",'\i[irr to ~o Jo'\".- tl'.is :o2.d: i:~:-Ybecame selr·-ces..:ribed New Keynesiuns,who continued t" h.'I'f':'.T ir '1" lcti'· ,0!': f( r ~h'glj·.'.'ml11l", .. Y ': e'" r they 'nn __th,:accepted the notionthat inn.',-;tnro;;arcl \' T.·"l!",'!"'; 11' r"r; ':i ,I inc' r 1;it 'lic;:-k::>l.; ::-~I,.,ld'11'" !;'~t it ri;!h

Of COLrse, ':llcre \\'er'~ ex,.'.;ptj.,'r~ (u t!1;:,c tn:nd:--:: a ['2''," ·;c':)[,(':1::;-·'; ch.:lI!el1sel: t~12dssLmption of rationalbehu\'ior. qU2sticr,L:_ ~::,~'-,t-ij.;,' .!-:.!:, fr.ancicl. m.Jrk:l' t:..i11 be ~ruSl:,J d:d ~uintej ~-:.Lhe lon~ history offinanciul crises thai k\J do::,'.1:,t;, tin:z t"t:ol1omic Cl)O:-;':CjI.:enccsCut chty \';~re swimming against the tide,unabk ~() nuke m:..:ch h\..;.!v·\;)" J'z~::tista per":l";;'.t: clcd, it". re:nj~f,-,d. l")u!i.sl1 cOlTIr:iucency,

In the l;>:~'\;-.~nF".:. --l.,r ~··tho:,;e nC'.. '~ran(:" , 1;:'

hundred plW[Ol.?;:-:lj"·', ~i'l '-'["I;':

,',):' " i, u.: [1:,"','-:-; r:idl"c _", Cor, + '.',;".~ct" -<ey:" compared them toJ ' j" t' f1" t-. (f •• Gt_l.lCl').~l.~ ::' ;' " j_.~tl('ix.;~r'.:'tt.L~L ace:) ron-In

iii', r 2:,'-,"<.1 1':11...! lu ,he' ell "'li:'\~'.it(·j" '.\'h ;~;.~.:boi,':l~ t11lJ:::tnearly corresponds tor~1J r~·•. l'o.: ",,:..! .;1;.)'.', "\J '-j~;'r :J' :1 '~"l:"pejt( r :::J:' tc FieI-;. not those faces

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which he himself finJ;~ pretties!.. but those that he t!l~nks likeliest to c.:.tch the fancy of the othercompetitors."

And Keynes considen:d i~a 'ery bd idea to let SL:ch n~arkeG. in which Sp2cu:1tors sper.t their time chasingone anotl1':~r's t.111-:;, .j:~t~tc ir.l;)Ort,int hu~;inE-s.:idecisio!":.::: "\\'ten :hE: cJ.pi~al d~velopm2nt of a countrybecomes a by-pmdu 't of th'2 ,1C;i\it:c~ of a cJ.~iro, the })b j3Ii~"el:' to be iJ-dole,"

By 1970 or 50. hf)i\l";CL thl' s~u,j,;of :-inancial r.1a::-keb S22me~ to r.3.\e bee:-, t.lkeu oYer by Voltaire's Dr.Pangloss, who insisted that we live in the best of all possible worlds. Discussion of investor irrationality, ofbubbles. of destructi'."C sp2cubtion hJd virtually disappeared from academic discourse. The field wasdominated by the "efficient-ma:'ket h\"pothe~i,.,'" pr<Jl11ulgatec by Eugene Fama of the University of Chicago,which claims that fin;,;ncial markets price assets precisely at their intrinsie worth given all publicly availableinforr:lation. (Th~ pr:.'l C'~.;) crmpclr/s s:ock, fIJI' exal1lple alhays accl;:ately reflects the company's valuegiven the infnrn"atiu J"ail.1,:I,e: or, ~Ile COm[Hm"~ cT:ning;; i:'~bU3in'~~;5prospects Jnd so on.) And by the198os, finance e,:') ,,«,min,>, nn~~hi;: \!irhael Jen~en nf the ~Jrv:,:,:'d Rl1sir,2S~ St:hool, were Jrguing thatbecause financiJl m2.r:,et~ <.d\'a~" g-=t prii..:es right t~l'; best thing cor~orJt-? chicfta:ns can do, not just forthemselves but for i.he ~<..ke 0: c,',,-' e(uf..n01Y, is t.; ~11<.iX IT:ize tl:eir sto..:k pri,::es. In other ',,"ords, financeeconomists belie-'I..'d that '{lieshoulJ. pL:t the capital de\"t:::lopment of the n2tiIJo in the h3.nds of what Keyneshad called a "casino, .

It's hard to aque thJt this ~f']I1·:form;,tiaJl in th~ pr0fes~ion "dS driyer. by events. True, the memory of 1929was grad ltally reced: ":S, hu t thne continned tc be bull rnarke t:-;,with widespread tales of specu lative excess,followed. by bC<:lr;:' :1- c~~." r r . ,)7'3',1- f,)" eXilm nle_ skd,s 10:::t-1-8 ?ercl..'nt cf their V:J lue, A.'1d the 1987 stockcrash. in which th' J If'", ih"l:,:-d nl 1r;y '23 per,..:er:t j, <l da:; for rr; (le3, reasr n. "hoek! have raised at leasta few doubt.., ab(Ju' ''''<.:rl''2t r;l~:; ,,"alil~;.

These e\"\.:nts, h()W\,:\;~-·. vdJid: I<l;~ne:-.''ioulo h~1\'E:mr.3idercd e'.idence of the l:nreliJbility of markets, didlittle to blunt the force 1)[ a bl..'aUiful idea. TilE thenretkal mudel that i:nance economists developed byassuming that eV€'i~vinn~~tnr t";J'ionalll, blance~ ri~\..a:?a~nst rewa.:d - the so-called Capital Asset PricingModel, or CAPM (rrnnounc.:pd cap-en') - i::-,:.-qnoerr:.lli·' plepnt Alld if _vOll2.CCeptits premises it's alsoextremely uscft:l. C.,P),I '1d or,"y rell,: YCU ho\\ to.:hoo:::c you" p/)r:folio - even more important from thefinJl1cial indl:str~":-- n,'i~"~o~-"i ',I', II t;,;l1s:iOU b':w tu put a Jric:~ on fin,·.l1(;:.l] Q"ri,,~ti':s.:;i. claims on claims.The elegance a~d ;1i""rlm~ ll' ,fdnc.:;;')f th,~ C:V' t'lcfJ:-y l.~dtl' :.l ~'trin'! of :.iQbj..p.Ilz..e~..;for its creators. andmany o~ t~..: the(ol~ '" "d":'~, i":, iff i':~f:nY)fI l11ullj·u:e r~\\':.llC': .~.:-ri1l:cwith tlKi' ney\" models andformidahle 1",lath ..;1,j ~~ - tb: ,:'j:'e <.II'C"J:-.e u~e~ of CA,?M rel.l,ui:·e I'h:v<;iL[~t-\evd computations -mild-mJr,J:t.:red hu,-i.l.2S, ..-;,dJ(I( l r;.""· '.>:-;ors cou:c 3.1:<1d:J Oelnl1L \\'.11; SIT2et rocket scientists. c3rningWall Street ~a:'t:bl\~,~.

To be fJi.:-. :'in In''e rl~l'f)~i:~t..; Jid'l't JC"f~')t the ef.icie·l~-r'ar~,e~ '1\'0nth.::-:i:' met"i~ly bec::JUse it was elegant.COnWl1iL"lt Jc.d lu..:r 1 :",~ TI'I'~ ,tl::" ,,,,'-/!'_:C:C '1 gr-=lt Cf J,1of ":;)".~'::e:': C'yidence. ,\'hic1l ~t first seemedstrongl~ ~L;:P()r::i\" I','. tb ,~ "--,=k:',.; ,;~'s ':f;1I1 cd,~I:'1j"'nite(~ fTr.-:. .. ;ii-:.a::1c2,.,-concmists nrely asked theseemini-dy obvio'.:::-" J. 'l":I" 1",_j _';j;-;;' :t:I-:V\ '~re i! r.r":l':-ticn)f" h,:th:r .)sset prices Elade .::~nse givenreal-w()r]~ f11,1(1."I:t"' .. ', 1:"-: --I ":s. i 1St "'/:. t~:'.'O:l.skeJ 'Jt:;~ ,yt :,:,rl:-~.:t pj,:e..; t::J;lJe sense giyenother :l~:'''-?:pricls, , I T} ~1.;11": ";, ", ,"lk:':' ';:' I'),'; C ,1(\ '~':: ir, ,,:',~:r-;r,aD<l administration. oncemockcJ f;nan·..:e ;'r"'- '<'j~" ,\"': .. "al'J'~ e ii'JI'" ookc,'hLp ~l" '1" . i,,'< '-[-0 "1:aH~ :;110\"1: th:lt two-quartbottles ')f ];"I.ehl..!' tt- ,lb12 ... ,~'j f "" l,~;ldl_; '""':'_'; J': J," ,ell ,I:~;Jr..,--c:'; ..it bCltie~ l)f' kdcilUp." acd conclude

How Did Economists Get It Sr \1., rctl!,,: ' 1\\,'1 il!l":s,,~,w:

from this that the ketl'!:up flldrket is perfectly effi(i~nt.

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But neither this mockery nor more polite critiq~les from econOl::i.;:;ls like Robert Shiller of Yale had mucheffect. Finance thcori5ts continued tc believe tha~ t;:eir mod~ls ,'ere ('~sentially right. and so did manypeopie making re<:il-worlJ lIeci;;i'J[h [";ot least ,1m(Jn~ ti12SI~w JS .\.b:.....~T.J:.~,~~Jn, \,'ho was then the Fedchairman and a Lm~-til11: sl.1pp~rter or financial de:'2!~ubtic,:: \,d~~s,-,fc,j,;:ction of calls to rein in subprimelending or address tl:e e)'e:'-:rJhtin,a; b':JUsing bubbie rcstfJ in br'.;e part on the belief that modern financialeconomics had e\'erything under control. There W::IS a telling r::lOment in 2005, at a conference held tohonor Greenspan's t,=nurc at the Fed, OEe bri.l\'e attecdee, Raghunm Rajan (of the University of Chicago,surprisingly), presented a p~per v\'arning that th~ financial system was taking on potentially dangerousleve13 of risk. He Wi.\Srnockct by almost all present - including. by the \/ay, Larry Summers, who dismissedhis warning~ as "misd; liclcJ,"

By October of last ~,CLI1. 11,)\';'-?':C". Grc\:'n:;pan \\ a~ a'];)1ittin's tblt he ""l"" ina state of "shocked disbelief,"because "the wh "l'e :T' tell ~ctlJ,ll .,',1' ~ice" had "l'():L~~'~d:'Sine': tl:is co\l::.pse of the iotelledual edifice wasalso a collap";/~ e-F :'l" '-wnr!d I::i.'r\;et~, +hc re~:ult '"a~ a scvert' rp~I..'.;:~i'~1- t'1C worst, b: m;}ny measures,sinee the Gred D~'r':-~..;.s;O:l,\-Vb:t ~I--, u1t1 policy maker~ d,)? lTnfo:t"Jl1Jtely. macroe;,;onomics, which shouldhave been providin;~ rleJr guidJoc,; JDOU h.-)w to i.!<.!dressthE' slup.lping economy, was in its own state ofdisarray.

IV. THE TROUBLE WITH MACRO

"We have im'olveJ ourselves in a enlossal muJdle. i:,:ving blundl-red in the control of a delicate machine,the working of \,'I1:el1 ',\'<:'; do r:Dt :l~l~l';_rstme, Till:' re~u:t is that OL:r ~'l~s;bilities of v\ealth may run to wastefor a time - pcrl".Jij,"; fer i.lll)l:'~ lime:' So wrote John Mayna:'d Kt:yne" in..ln esslY cded "The Great Slumpof 19:)0," in which be' J';,:d co ':':irlain tl-e e:.itastn;pn,= then ove:i:a;:i,.g the world. And the w0rld'spossibilities of W'~i.!:Ul ,liJ iil..kd rU:l td waste (,)!"'-2 l()n~ time, it tJuk Wc!"ld \'lar [J to bring the GreatDepression to a dell"litlvc C:ld,

Why was Keynes'..; diJ!!flOSis t)f ~heGrc..lt Depression as a "colossal meddle" so compelling at first? And whydid economics. c:r(',l '9-.). di'irlc into 'ip?osing camps 0H'::" tl~c \'aluc of Keynes's \iews?

T like to cxpbin ~:,' '~""el1t't '}r' K~'~;· :-;::.ll1 eC0i10r.l;CS \'vjt:h i.l ~r;.•'2 ~t,);) th:lt i.lls,) SI~lTes as a parable, asma:l-st:Jlc \'e:'-";rl1 . f ~h~1l:1~:--L:, tLi. L"n ;,dlit:~crr:r ~(CU:,,;:li S.,'l n::,(~e:- the: C;J\ ails of the Capitol HillBaby-Sitting CO-'Jp.

This co-op. '" ho.:'c DiL' ,1'::111- II, _ '~. :'.:t ),tl-,kd i'1 .:. [Ct';";:- ~, .. :i'_I':: ';-. : .. ,- ,,' .~ll1Ji uf :,Ioney. Cr::dit and B'J.:l~(ing,was an ..ls:"()ei~tiol' ,f J.bOilt l;)u you::~ ccup;t:s \\~(J ,1~4reed to he:p Ine another by baby-sitting for oneanother's children \ovlk'n pJrent., wanted J night out. To ensue tl12t e\'el~, couple did its fair share ofbaby-sitting, the CfH ,p intrn(:u.:ea 'I fJrm of scrip: coupons made out of heavy pieces cA' paper, eachentitling the bear':r L( Ilne ba:;"-~()l:r c --;-ittin.!Ztjn'.I~. !r;iti:Jl>y, nem',e,-, ::-ecei\',~d :.m coupons on joining andwere rel{uired tc r,,~t"''''l tho, " '-'~,:;::(l'.lnt (F. d'Tarh'l; thl '~rr,Ul1

Unfortu'li.Otek i', :- r' ......:!~ .It.'~: I \1': '~"-')P', r~..:: lbc "'. l,r. ,I .. 'J": ,d.:d tc :11)k:.l rt:scr';e or m'~ie than20 coupe;):;. perl~a,)~,. If; '~:l~c,:-~ -:llJi..k! hJ.n~ :1, :!.' cut :-;~\',~.11 ilW- ..:" ro":, .~s J re:-;t:lt. relati"ely fewpeople> \,\;H:tC.1 t .. ,;' I''; :'··.:i_' ~', "':" :- _ :re;,r; It. I, hi',; '~:;:l'" " ...lL, : :,' "':1,,:, ·.;;i: ,u :Lc.:y could <led to theirboard, But ,-inco::'h;lh .. -:'lti!~g "()"')I,": .n:t;es :.l:i~(:en::. ":h'~n SC!TII:(iI:e!!;..S 'Jut :'or the nig:l:t. thi..; meant that

lIow Did Economists Get It So \\ roll;'? - l\YTilllCS": ,)1-.1 http, 1\ \',\\ n~tin'e~,com'2009 0906 mag,azine'06Economic-t.html? ..,

baby-sitting jobs ',VI;:'C hard tu fine. whicb madE; lTembers of the 20-0P eVe!l more rE:hctant to go out,making baby-sittin,s jobs ~\'cn :,c:m'er. , , .

In short the co-op fell into ~lrecessi':n.

O.K .. what do you think of thi~ ::t,)ry? Don't di::mi~s it as silly and [rh-ial: economists h:1\"e used small-scaleexamples to shed light on hig qu .....sti(,f.s ever sime: Adllm Smi:h saw the roots of economic progress in a pinfactory, and they're ri;sht to do :-0, Th,; question is wl:ethcr this particular example, in which a recession is aproblem of inadequate demand - there iSC1'tenoug'l demand for bahy-sitting to prO\ide jobs for everyonewho \\'ants one - get.., at the e~:'en,:e I)f wh<lt h1ppen~ in a reces::ion.

Forty years ago ,1lest econonli::;b \\ :)llld !-,ave aereec with t~lis interpretation. But since thenmacroeconomics hao; llividcd in':o h' 0 great factions: "sa!t\-v:lter" economists (mainly in coastal U.S.

universities), who 1lJ.\ c a mrJre or le~'s Keyn,~si:.ln visicn of \\,hat recessi'ms are all about; and "freshwater"economists (mainl'" ;i~iJ:IaJ~d stho'1{:':; \\'ho COI1,--iller that \ isi')!1 nnnsi.XSC,

Freshwater economist:o are, c;;s.~nli<t11y,ceocbss:cal pllris~s, They bclie',e that all v\"orthwhile economicanalysis starts from th.,; premise that people are ration31 and marh::ts work, a premise \iolated by the storyof the baby-sitting co-op. A.<:, they see it, a general lack of sufficie:1t demand isn't possible, because pricesalwJys move to match surpl~, with denland. [f people vvar.t IT,,-'rc:-bby-sitting coupons, the value of thosecoupons will rise, so tlLlt th :,y'l'e wor"':~, say, 40 minutes of b~b~'-sit~ing l'1ther tban half an hour - or,equivalently, the co..-:tof ail h·mrs' h:'~)~'-E:itting woulcJ ,'JIl f~orr. 2 cnupo:l.s to 1..'). And that would solve theproblem: the pUrCh~bil1~ po'\cr pf th':: coup,m~ in cirndatjon would h;r;e risen, so that people would feel noneed to hoard llO'm:. :incJ th(;r'; "'()l'~':! nt' no re.,·~,.;,.,iOil,

But don't rCCt:ssi'il1;; !,)01: Ii k ....r':~iod - to wb ii'll tl-.,;!'.,;j~J.,t i;jl'~ cr,( uµ-h demand to cmpl,)y everyone willi ngto work? .--\ppcaran,:,.s <'\1I~ hi:' dV{".:"in'Z sa;' th~ rrE~h'v_'kc tr.;ori.;ts, S/)I.lnC econol"'lics, in their \iew, saysthat O\'cr<.lll faih!r;:~ of demJlld I:ar't ,upper - <lilt! tha~ me:.l'l:' th:J: ~hey dan ·t. Keynesian economics hasbeen "p ,ov.:d fa'st.:,'· C,)Cbr:1 ,12, If the Cni\"er'.;i!".';llf l'hic:.i:-;o, s:' YO",

Yet r-:cessions du h~:ppl~n.hhy'? I:, the l,:)70S :he le:H.:ing fre..,hw:.lEer mac:-oi;conomist. the Nobel laureateRobert Lucas. Jr:1;ued th2t n:lLs,;:ion:~ v,'ere caused by temrorary confu"lon: v\orke~s and companies hadtrouble di~tini-Sui~hin'! a-,wall ChLll1;:'l::~in tIlt' If' pI ot' viee~; b:ca':,~e .:,r intl.lti(il1 or Q~tlation from changes intheir own partiClI1:r hl!:--.inc~ssi!._Jlj,:;;, :-\nd L1..I':1.';V,:l:'~c,J th:lt ,1'l:'t~kLlpt b) fight the business cyclewould he ctJunk1'p:', dIll ~i\ -'. :\. ti',i.~1[ltl'icil:-.. h~, OJ-'LLo;:IJ,,,;> J'J l:'t :',j,J t) tlle cnnfu~i\)1l.

By the L9~os, ho.n ", r, ,;n~r:h ,S .-:,•..f r .,+; Iim:tc, 1 "'i.:L"l~r:;'t:lLl:: ,,f :i:L :'-:l';': th.lt l"l:cc:5~ioi1sare bad things hadbeen rejeLtecJ Jy 1:1 .. ,. i'rl'~,1\';'l~r ,:Uj·l\).~li:;t.:;. Inskud. the 111;\\' >21U,;r:-i c.t the moyement espedJlly'Edward Prescot:, ·.d111 was t:~el':.:it th.: Uni\'ers;~' ot:;V[i!1J1e~(<.':l ,:OU 1.':,11 ::e~ where the freshwater monikercomes frc,m), Jr'!'J\ d l"~a! ~~;:~ ~1-:I:~:':i~i().1Sand eh.:n:r·;..; :c. cl'r-;::-.d 'l::ua!t; [,ad nothin~ to do with thebusines" cyciL. R I~' ' th~ h :':;:o:.':~:' '~ .::'- re "~~'L:'- f UC'JJtiors in ti~c r.' [e \If k,:hnc logical progress. whichare Jmplified r~t1'., -It:nr:;;,l r,:,'pc;.-.:'e )f \':P,k,'f-. 'I·~'.,' \"r.::11ll1~a::~. lin',: l~lorp \,\'hen the emironment isfayor;Jble dnd le';'~' , t' if,' I.i~-'"('~~ir,L l're;:nl.;: 11' _rt i:: 1 >!.h,~r~l~:,J'~ci:-;i'm Ii,' 's,)l'kers to take timeoff.

Put h<lldl:: !i,-:c -hL,r ,i i;: ::1t.':;:"" ",I "';.' :,1):+ - W:'I" [;-" ;re 'I 1-' P!'I"':O" re'll!:, ~h,; Great Va':ation? ,-\.ndt.) be hll(':,·"1. r tj-,:"" 1-" I ' !< ,db [~111 h:' '),,-:~i' -r' 'n:~1.. :t ,;n> '[,'(..-: ....,,11 l-,u::inc:-.~cycle" theory was

How Did Economists Get it So Wrong' - Time~ con !mp: I '." \.\.,\ r.!ti'1~es,com :00909 06 'magazine 06Economic-t.html?

embedded in ing8niously constructed mJthem::J.tical models, \\"hi,:h 'were mapped onto real data usingsophisticated statistic.lI tech!1iq:'12S, Jnd ~he theory came to dominate the teJching of macroeconomics inmany university depJrtm'~llls, Il11(l8_~, refecti.:J.g tte theory's int1uer:ce, Prescott shared a Nobel with FinnKvdland ofC;Jrn('G"l:' :-!cllon l'nin~rs;t\"."" - --~- ------ --_. --

Mean'while, salt\\at/~r ,:':onon-isi...,..:b.ll:~d. Where the fresI-.w<Jter eco::lOmi~ts were pu:ists, saltV\-atereconomists were pragmatists, vv11ile economi~,ts Eke No Gr~Q..r\" J\lill1ki1s i:itH;.m;arg, Olivier Blanchard atM.LT. and David Romer tit the [Jni\'ersity of California, Berkeley, acknovdedged that it WJS hard toreconcile a Keynesian demand-sid,~ view of recessions with neoclassical theory, they found the evidencethat recessions are, in fact, de[111nd-dri\"en too com]elling to reject. SC) they were willing to deviate from theassumption of perfect rnarl:ets or perfect rationali~" or r.iOth. <.:dding enough imperfections to accommodatea more or less Keyncsi:ln viC'w t:,f recessions. A,,"1d in tbe stilt\\,,'..tcr viev;, ac~i\'e policy to fight recessionsremained d'~sirable

But the self-d2scriht:d 1'iew K':y-esi<: 1 e,:onomi,b 'weren't im:llune ~c ~ho;charns of rational individualsand perfect markets They tril:c 'J hep their devi:ltions from necclassica! orthodoxy as limited as possible.This mC;Jnt that ther:: W:.l~; no renm in tlle pre';ailing models fa::-such things as bubbles and banking-systemcollapse. The fact that such things cO_ltinued to happen in the real world - there was a terrible financialand macroeconomic ('Ti~.;isin n1!lch of A5ia in t9Q7-K and a depression-level slump in Argentina in 2002 -

wasn't renccted in the l1lain~tream of New Keynesi::m thiGkin:~.

Even so, you might ba\'c thoL.gbt that the differing wcrldvie\v:i of fre~hwa:er;J nd saltwater economistswould l:ave put tJlem con:it.lpl:ly at loggerhe;Jds o':er 2con0mic polic::, Son~ewhat surprisingly, however,between around lq~:=: and 2()07 ~he IJispute.' br-tween freshwater and ~altwater ecm:omists were mainlyabou~ theory. nct ~ir:li()n Tbe rt':J:'O'l. r b:lieye, j',; :hat New Keynesi2f5, unlik~ the original Keynesians,didn't think tisc;,l! policy - ('h.1ll~~':sin ;IO\'ern!11cnt ~pl'ncin~ or t<:lxe:,- was needec. to tight recessions.They believed tlut nonet::lry policy, 3d:llindered by tl-e tecb:1ocr1ts at the Fed" could pro'vide whateverremedies the econ0my m~eded, At 1 ooth birthday c'2lebration fl)r Milton Friedman. Ben Bernanke,formerly a more or jL:SS l'iew KC:-Tlcs;aD pro fes:.;r;r at: Princetcl". and b) then a member of the Fed'sgoverning board. d;:,:c1a~edof the Great Deprcs~i()l1: "You're right. \,,-.~did it. vVe're ve~; sorry. But thanks toyou, it won't l:aptJ,;,r; ~~ain." :'h~c1t':.l~mes~:.lge was that all :-ou need ~o avoid depressions is a smarter Fed.

And as lor..g as tn::crol:<:o:--0!11icr'l)lic'" 'iIi;::S left in t~e ;,ands of thr.: ma2~tfl) Gr'::enspan, withoutKeynesi:m-type ·;1:,,'1.111:-; ?rf'!iT'l·':i h:",,\\"~~~?r':1.:00 ll11isl,:;~·O,:cr.i lit~: :0 eomplait. about. (They didn'tbelieve that mOl~d"lr. pol:<:\ ,lid ln~ :!l)c,d, h;]>they didn't heh::'"(' it .:id <:lnylnrm, either.)

It would take a c::-i::j,,;lo n,vl~,,1!bot;, bm·.. littl.: commen ~rour. j thLr2 \\',b Jnd bew P:mglossian even Ne\NKeynesian econom'!,:-j haLi hecurae,

V. NOBODY COU.iI HX,T ~REf'rCiEL· , ".

In recent. rueiu12ccj ;n;(~ 1.1::~':U:::cil)cs,all J.1l-purpllse puncL li-k hJS Jccom.: "ncbody could havepredictec., ". ," It'.; "l ,1~ \'()l" -,,\" .,i;~"L:;gJr:: tc =bas:-=rs t~l..lt-: H... ·..: :1:;-.-1;bEen ?reGicted . .3hould have beenpredicted cmd adl. I::, ' '.1' 1=" ,Ii,,', ! h J C''.:Lor ,:ll:S~', • ',n 'l[', ".!lf~ed;2i: for their pains.

Take. for eX:.lIllplt:. t!J,: prt::cip: tOllS ri,-e ,Jnd fJ;] )r'l:i)usi~l'! pri,:es, :3on,e ecnonl"1ists, nc:ably Robert Shiller,did idenU~ th: !x,bi'k ;,l~J \~,]t" ' ,If l'l;I'I'l,ll'cn.<.,,:q.:\..t1L·:-j it i \\\....'~tc ; urst. \ t't kc::' policv' t:lakers failed to

How Did Econolllisls Gelll So Wrung" - \JY'] me"l.'),l' 'ltlr :" v' \\ ,,\ ,n~lin;~s,':om 20G9 09'06 'magazine,'06Economic-t.htmI0 .. ,

see the obvious. b 20°4, ~J;}n (~re ..~n.-;pan disOlissec'. talk of a ho;.l~ing bubble: "a natioml severe price

distortion:' he decl:J.red. wa~ "r.:ost unlikely," Home-price incre'-..ses. Ben Eernanke said in 200.5, "largelyret1ed strong ecooomi,..: f:.mdamentaL;;,"

How did they miss tl:~ bubble? To be f.1ir, interes': rates were un~lsually low. possibly explaining part of the

price rise. It may he tInt Green~paf' .:I,d Be,'n~:nk-? uJ.-:owanted t,) ct'lcbrJte the Fed's success in pulling the

economy out of the 200 1 rece~sil)n: conceding that much 0:' t!nt succ\~ss rested on tl:.e creation of a

monstrous bubble w')l:ld lw\'t~ placed :-.damper on the festi\'ities.

But there was somed:.ing ei;;~ going on: .1general belief t.hat bubbles just don't happen. What's striking,

when you rere.1d Gr~enspan's ,l:,SUr<lnCe3, is that th",'y weren't 1ased on e\idence - they were based on the

a priori assertion that there simply can't be a bubble in ~l~usiIlg, And the finance theorists were even more

adamant on this point. In a 2007 i:1tef\iew, Eugene F;lma, the father of the efficient-market hypothesis,

declared that "the \'::1,d 'bubhlc' dri\'es me nuts," and went on to expbin why we can trust the housing

market: "Housing n:arbts are less liq~lid, b'Jt ...e')plc ::lre n~ry caitJul when t\1ey buy houses. It's typically

the biggest im'e~tmert thf~y're c )in'l; to r.1ake. S0 the~' look arc",lI1J ':ery c..lrefully and they compare prices.

The bidding pn)L'f~:-oSi:- \wy deLl'le~l.··

Indeed, home bl1;:er~ genl~r;]ny r:!'J carefully com;Xl.re p:'kes - tl:.2.~is, they compare the p!'ice of their

potentiJl purchJsl~ lvith the prices of oth~r bouse:;;, 3u~ Ihis SQ::S n )th:ng about whether the overall price of

houses is justified It'.; ketchup economics, again: because a tI\ o-quJ.rt bettIe of ketchup costs twice as much

as a one-quart bottit'. tban-:c theorists declare that tl1e price of ketchup must be right.

In short. the belief in dficicnt fin,mcial markecs blind(~d many if not r,l0st economists to the emergence of

the biggest financial buhble in !:istor':, And df.cient,market theGf)o al30 playeJ a significant role in int1ating

that bubhle in the fi r~t pl<lc(~.

Now t~at the ur:ui;'::';i1USl'd 1:·IJI)hl., hcls burst, the t:·uc riskinesc; of;uP\1osedly :3;lfe assets has been revealed

and the financial ~Y:3t'~rn h<.l'-llc.~!110n,'tr;.:tf~dits fragility, r.:.S. h'JuscholJs have sel~i1 $1:3 trillion in wealth

evaporate. l\t[ore Lll:l six million j< b~ have been [0,;;,. an,j the unel~1p:oyment rate appea::-s headed for its

highest level since ll)-tO, So what guid:ll1ce COl'S modern econ()l~1ics ha"e to ofr'er in our current

predicament? Ard :;hould \\'e tru:-:t i~',)

VI. THE STli\lGl.L".' :'O!..'.\BI3L:':

Between lq8:') and ...:';1-.: f.:!.-:~ r.CJ~I. ~e':tled 'J,-er tilt:: fiel~ )f :-l~'·T(' ~l~:j[wmks. There hadn't been any real

COl1n~rgence of \'ie',\, ')et',,, "C.l t.-,~ ~,-,_t'.\;;lterand fre:;hwJ.ter r·JctiCl1:;. act these were the years of the Great

ModeratioCl - an e:\ el1CtrJ Cd:<'': (:::rin.~w~li.:h inL,]j -.n ,v<.1.; ,;;;,I!'dl.:eC,and r:~t:essions were rebtiwly mild.

Saltwater ec()nomi~ts l;eb~\I::J ,:Jt ~'-.( F,=derc.l R(~St:'l"'e hac t:'\cf':h,n;,:: under cunto!. Freshwater

economist:; didn't t:link the Fed's aCr:(I1,~ were 2CL:l:"it" :)I~ndlci<J.!. but they were wil1in~ to let matters lie.

But the crisis ended th;.. ph()i~) p<:'<lU;. Suddenl:, tb: narrow. technCC:ltic policic:; both sides were willing to

accept were n,) l()n~'~1 ";Ui"[jl'ic::;~ - wJ the need for ;1bro:der I:l)h::-- t"~SP()OSi': brought the old contlicts out

into the oper:. fien.'l'" .:1:n; C" 'I',

How Did Economists Get It So \f"r')Il~'? - !~YT,l1l~s,com http:' \V\~\\ ,li:,ti:l1es,com'2009 09/06linagazine,06Ecollomic-t.html? ,..

During a normal rec(~s3ion, t:le Fed respond" by bu}-ing T:'ea:-urv bill,;; - short-t=rm government debt-from banks. This drives intere~t rates on go\'ernmer..t debt down: in\"estor~ seeking a higher rate of returnmow into other asset~. dri,i',lg other interest rutes c!o"m as well: and ::lOrmally these lower interest rates'even':uaJ1y le2d to c',nC"onon',iL hounr..:eback. The Ffd dE-~1twith tl,e recession that began in 1990 by dri\ingshort-term in~erest rates fror:! 9 percent down to 3 percent. It deo:Jt with the recession that began in 2001 bydri\ing rates from 6.f=, percer.t ~o 1 per::ent. ,~lI:dit tried to ded with :he current recessior: by driving ratesdown from 5.25 percl'nt to zero.

But zero, it turned out, isn't low enough to end this recession. And the Fed can't push rates below zero,since at near-zero rates inwstors simply hO<:lrdcash rather than l'C'nding; it out. So by late 2008, withinterest rJtes basically at what macroeconomi:;ts call the "zero lo\\er bO'Jnd" ('\'en as the recessioncontinued to deep'2n, cOllver-tional m0netary policy bd lost all tr:lctiron,

Now what? This j::: ':hE secane ~ime Am~rica h:::s been up ~gai~18: Lhe 't.ero lower bound. the pre\iousoccasion being the Great Dcpressioti. And it WJS precisely the oOsl;(\.'ation that there's a lower bound tointerest rates thJt led Ke.,nes ~oadvocate higher g0ve;nmem spending: vvhen monetary policy is ineffectiveand the pri\'ate sector can't be pcr5uJd,~d to spend more, the public ~ector must tJke its place in supportingthe economy. Fiscal.,timu]w; is the KeynesiJn answer to the kind of de;lression-type economic situationwe're currently in,

Such Keynesian thinking underli'2~' ti1e Obama a:lministration's ecor:omir: policies - and the freshwatereconomists are fl.lriol.l,";.FO;':25 (Ii' so years they tolcra~ed the Fed's ef'r"f)["tsto manage the economy, but afull-blown Key'lll'si lD n~sur'~o r:.ce w:J.~:3ot~ethi!1g entireiy diffe~·ent. B:1ck in 19.:30, Lucas, of the University ofChicago, wrote tha~ K~:;ne~i:l;l economics "\'as ~o :udicrous u~:.1t'"3t r2seareb seminars. people don't takeKeynesian theoritin'l ~;eriously anymore; the :::.udien,~e starts to whi<;per and giggle to one another."Admitting that Keym:i was brgdv ri~bt. after a!l. would be too l;'Jmili3ting a comedown.

And so ChicJgo's Cochrane, outr:lged at the idea thJt government spending could mitigate the latestrecession. declared: ·Il'..; Ill)( pClrl of WI1'lt anyhcd:; has t.lUght rsraduate students :,oince the 1960s, They[Keyn,~si<ln ideas] arc :'~'irv t.lle, tha~ ~12';e rccn p-on~d fJ.lsc. It is ';cry nmforting in times of stress to goback to the tairy t:J.!e..owe ~1f~<.lrd'IS d"i\drer:., bllt it d'.Iesn·t ma:-:8 th2111Ic~s false." (Il's a mark of how deepthe division betweu: ,.,altwa~ r ':nc1 frc"hwi.l~er runs thac Cod:ra.:-:e dr),_~n t helievE- tbJt "aoybody" teachesideJE that Jre, it, f;,;ct. tat..:,~ht :r oLcl'~ 1'ke Prin,:e~0'1 YI.I.T. and Har\"arrl,)

Meanwhile, salh\ atl r t:connCliscs, whu hJ.d comf(lr~(J them:-clws ',I. 'L1 the belief that the great divide inmacroeconomics \\"a:-:narrowing, Wt~~e:;hocked to rea:ize that frf::sITI.\':J.te'·economist.:; hadn't been listeningat all. Freshwater (~\" :lOili"t., \\ i'l) :n': 'i!!hed <'t! 11 l~,tthe stil!'lllu< di In't :-,ound like ..ocholars who hadweighed Keynesian a<.;umen~s J,e f ,und tb<::'ll I,-'a:-ti::l:s,Ratner. -nl) s'Juncled like people who had no ideawhat Keynesiao eco;-o l',~;cs \,\J:-' ab(,l' t. '.\ ho 1,'t'r·.-: "..':--'1rrp.dinf: pr ::-ll. ,Jl blbcies in the belief that they were'aying so~nethi:}fr .: ';-\ :1:,t! ~:L")~o)u,c,

And it wasr: 'tju::-t K,_) EC:; '" ]'1),<"icc~,:- o,CCl':'lCJtOJa' 'i~ c.et n f(,nu, ttl~r:, ,~,.;;Brae Dp.Long of the Cniversity ofCalif,)rnia. Berk=.:ll'. '!~..; pc'i:-t.:d e'l: ::' ~l::-;b:-n'~r:~ ao,)u: tl:e C:::a::u ..:c1100r5"ir:teI:ectual collapse," theschool's Cll~rent o,t. r, •.!!l1ClI"1t<tl) a'" i-,olesalc :-tjet':io:l of ~,rJ~l)r:F-,~d:nJt1', iue<l~, as well. Friedmanbelieved thClt Feu p.;lil~\i"lt!'l:r :hai1 .'ha~lge.; ir \lo\ernment ::';)erJing shl)Uld he u:;ed to ~tabilize theeconomy, bllt he t1l\ I I' !:-'''e''t''(! that- 'Ll ;'1Ct' :<'>1' :n !n';erll~K"t 'DC1"j;1,~ cannet, under any circumstances.

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increase employment. It: [<lct. rereac:ng Friedman's 1970 summ:Fy of his ideas, "A Theoretical Frameworkfor Monetary Analysis," what's striking is how Keynesian it seems

And Friedman certainly ne\-er bought into the idea that mass unemployment represents a voluntaryreduction in work effort or the idea that recessions are actually good for the economy. Yet the currentgeneration of freshw:.1ter economists has been makin~ both arguments. Thus Chic<lgo's Casey Mulligansuggests that unemployment is so high because many "vorkers are choosing not to take jobs: "Employeesface financial incenti\'cs that encour,-~ge them not to work ... decre:,sed employment is explained more byreductions in the supply of bbor (th~\"i!lin;;;ne~s of peop:e to werl-;) ;:nd less by the demand for labor (thenumber of workE rs thLit empl ..Jyc'rs r.ced to hire)."' Muiligan has suggested, in p<lrticubr, that workers arechoosing to remain une~1ployeJ because that impro\"t:s tb.~ir odds at recci'.'ing mortgage relief. AndCochrane declares that high unemployment is actually good: "We should have a recession. People whospend their lives pounding naib in i\"evada need sOr.1ething else to do."

PersomIly, Ithink this is crazy, Why should it take mas:; unemphyment across the whole nation to getcarpenters to movc cut of N~vada'? Cn anyone seriously chin that ',"e've lost 6.7 million jobs becausefewer Americans \\'am to work'! B:Jt it was ir.e\it:lble that freshw<:>.te:-economists would find themselvestrapped in this cul-cle'-sac: if ::()I.I st;l~'l from the assumption that :Jeop~e are perfectly rational and marketsare perfectly effiri 'nt. :-nll 11:1:f' to (nrc!ude that lInempI0ymt-~nt i:" oluntary <:p.drecessions are desirable.

Yet if the crisis has push~d tTcshwater economists into absurdity, it hJS also created a lot of soul-searchingamong saltvvater economists. Their framework. unlike that of the Chicago School, both allows for thepossibility of involLdltary unemployment and considers i~a bad thin,:;. But the New Keynesian models thathave come to domiG.lk teac1lin;.:; a:,d rcsearch ~lssume t':lat peop:e are perfectly rational and financialmarkets are perfectly efficient. To get :mvthing like the curre!lt -::lump into their models. New Keynesiansare forced to intndL'cc 'icn:e ki:lod r-,Id~e facl")r that for re:.l~ons Ul:~peciEed temponrily depressesprivate ::ipending. (L,_' donf~ t'{:'ctly th"lt in ~or.-,e of 01\ ov\ n ,,,orl:'-I ..l..r:d ~fthe analys:s of where we are nowrests on thi:, fudge r';)"tGr, b<1\" rrudl cOL<t"idenceca:1 we h:.lve in tlle '1:od~ls' predicti,ms about where we aregoing?

The state of macro. in short. is :ot good, So 'v!"1ere doe:: the vcfessiOl: go from here?

VII. FLAWS AND FRJC..ll0N~

Economic~. as Q f;..:IJ.~ol in trt!ubl':C h::I..'a'..lseeCOl,or:ljsts were ~eJll~t'd by the visi0n of a perfect. frictionlessmarket system, If t.l .. ,)r(J!:e:.;,";:I n 1,-';[( redeem i~self. it will ba\ ; t) I·CCI:IJ.ciJeit·elf t'J <.! le:;s alluring vision-that of w l11Jrket ev ; .:':::t.:Lt i',;::~":.:lny "ir~ue~ but ~~1.Jti-' Z:.!:-e:;'~()l t~rC'.lgh '\"ith tla",'s and frictions. Thegood new~ is th:lt"..: l,o't h:1 -I, ~;) ':t:llt :':-om ",::"ltcb. E\er: dL:r;r~ t'~,_ heydJ_' of perfect-market economics,there wa.s J lot ofi,\urk UO[j'; 1m t:k 1";l\'S in wl':.;..:h tl:'2 real eCll,H r.,\ c.e'.-iated [rom the theoretical ideal.. '

Wb::rt's probably '.!nin..!.to hLipper r.o',''- - in fact. it's alreaJy haprenin~ - is that tbws-and-tTictionseconomic~ will !11{Jh; frol1l the reripl'ery of I'C~)ll';r.,ic analysis to ir~ '..:emer,

There's already J fa.i,-!-' ,,-eil ii.:., t+::.pcd exampl,= of t",1~kind 0,' eC'Jl1():r.:c~ I ha\'e in :llind: the school ofthought kno\\ n :1:' hl)l~ lyil)rJ I r1 "2.I1C0 Pr:..ctiti'Jllf:"S )r tb ...o.r:-:,rr:'l'..:h t=:llphasize t'xo things. First, manyreal-world in"estljr~ ~'c~lr linl.: ,~s''crlbla:lce t,: th cool cakt.:bt()r, c 'effcient-market theory: they're a11 toosubject to herd bcb:l, I):, tc l~' ;t., rf iFatier,:,l! e,oh.,Cral1ce JI1..1cn,':: ;-ranted pnic. Secorcd. even those who

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try to base their decisions on cod cak ...tlation often find that they can't, that problems of trust, credibilityand limited colbterul force them to run with the herd.

On the first point: CH:l' d'lring the heyd2Y of the efficient-market hyuothesis. it seemed ob\ious that manyreal-world investors aren't as rational as the prevJiling models assumed, Larry Summers once began apaper on finance by declaring: "TH ERE ARE IDIOTS. Look around." But what kind of idiots (the preferredterm in the academic literature, actually, is '·n·)ise traders") are we talking about? Behmioral finance,drawing on the broader movement kno.'l11 as beh:1\ioral economics, tries to answer that question by relatingthe apparent irrationality o~'investors to known biases in human cognition, like the tendency to care moreabout smalllosse.-; than ~m1J.llg~linsor the tendency to extrapob.te teo readily from small samples (e.g.,assuming th3t beca~3l' home prices rose in the past few years, they'l! keep on rising).

Until the crisis, efficicn~-m:.Hket advf)ci:1tes like Eugene Fama dismissed the e\idence produced on behalf ofbehavioral finance :1,; a collection of "curiosity items" of no real importance. That's a much harder positionto maintain now that the I:olbpse of a vast bubhle - a bubble correctly diagnosed by behavioral economistslike Robert Shiller of Yale, who related it to past episodes of "irrJtional exuberance" - has brought theworld economy to it~ knees,

On the second point: suppose thJt Ihere are, indeed. idiots. Hovv l11w:hdo they matter? Not much, arguedMilton Friedman in an i:ltlue;ltiaIICJ5:3 paper: ~mart il1\'estors will make money by buying when the idiotssell and selling wher they hlJ~'<lOd\vil! stabilize m::trkcts in the praccss. But the second strand ofbeha\"ioralfinance says that Fri( cn:an was wron;s, that fiuJ nda: ma::-ket::are sometimes highly unstable, and right nowthat view seems haLd to rcj~ct.

Probably the most int1uential p<.tperin this vein was J 1997 pc,blicdion by Andrei Shleifer of Harvard andRobert Vishny of CI:icago, which amounted to a formalization of the old line that "the market can stayirrational longer than you can "ta~ ~l)l"ent." ,4,S they pointed out arbitrJgeurs - the people who arcsupposed to buy 1mV' <wJ sell high - need Clpit,ll to Jo their jobs, And. a se';ere plunge in asset prices, evenif it makes no sen:"~ 111 t_':'m:-:(\f hnd;JI1~<:ntals. L~nc!sto deplet~ tj:cl~ .'J.pitJI. As a result, the smart money isforced out of the ma"~-:et,and p";ccs JT:.:.Jy go into a downward spiral.

The spread of the cu:rellt fin;1neia: ,;[1;;j:> seemed ::l!JT,ostlike an OtJject lesson in the perils of financialinstability. :\nJ tJ:~ d;eneral ideas undalyin:z models of financial :nstability hJve proved highly relevant toeconomic policy: a f,)clls on rhl~depIcted capit..tl of financial i:ls:ituti.)ns helped ~uide policy actions takenafter the fall of 1,e11I11<1I;. and it loob (l.:rossyour fin;.;ers) as if these actions su!.:cessfully headed off an evenbigger financial c·.)lbpsc.

Meanwhile. what <1hl)l!t m<h.:r00conll:-nics?!<l'C.!i:~e"ents ha';e pr~'t~ d,:cisiwly refuted the idea thatrecessions arc an (1)1'11:1] rt-::-:!)('.i~e t, tlu:h.:..ltinn:; :r, the r~tc ')t r-.c!- r:olo-.;icJl pro,~ress: a more or lesKeynesian \ iew i.~L:J_ ')i.:~ plclL,~ih!Lg;",;:lei.i L(J" L Ylt stanL<Jr:.. :-:e \ r.:t;~,n2sbn mode!:; lcft no room for acrisis like the 0'112 ,,,-,_'re hJ'ir z h:I':lU~e tho::e n1Jd21~~eneraL\" cl':ce~ted the c~ficient-market '.iew of thefinancial sector,

There were some 0x.:epti\1O:-:,Ol1e iine ,)f werk, pior:et.r:d by i'O::,,' Jther than Ben Bernanke working withMark Gertler of :~\.'\' 'l-C)r~_l"ni'-_er~ilj_,l'mpha~i~:ed"Lheway tilt' bcl,; cf sufficicat collateral can hinder theability of bLlsinc:.;,;(~St . raise. 'ul:d~ cl'lC pursue in- cst'lJCn~ l.)p!~ortu:litk..;, .-\ related line of work.lan:;ely

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established bv mv Pri.nceton collea!!LleNobuhiro Ki',-otaki and John Moore of the London School of~ w j_, -'

Economics, argued that prices of assets such as real estate can suffer self-reinforcing plunges that in turndepress the economy ns a whole. But until now the impact of dy::functioilal finance hasn't been at the coreeven of Keynesian economics. Clearly. that has to ch:mge.

VIII. RE-EMBRACING KEYNES

So here's what I think economif."ts haw to do. First, they 11Jveto face cp to the inconvenient reality thatfinancial markets fall far short of perfection, that they are subject to extraordinary delusions and themadness of crowds. Second, they have to admit - and this will be \'ery hard for the people who giggled andwhispered over KeylleS - th,-1tKeynesian economics remains the best frame'work we have for making senseof recessions and depressions, Third. they'll have to do their best to incorporate the realities of finance intomacroeconomics,

Many economists \,'ill find these changes deeply disturbing. It \\"ill be a long time, if ever, before the new,more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness andsheer beauty that ch:lract,~rizes the full neoc\a':isical upproacb. To some cconomists that will be a rcason tocling to neoclassicism. dcspite its utter failure to make sense of the grcatest economic crisis in threegene-:-ations. This seems, howewr. like a good time to recall the words of H. L. Mencken: "There is alwaysan easy solution to e\'ery Iwman problem - ne'lt. ploilsible and wrong." •

When it comes to the all-to,)-human p!"oblem of recessions and depressions, econonusts need to abandonthe neat but wrorg solution of assuming thQt everyone is wtiom! and markets work perfectly. The visionthat emerges as the profession rethinks its foundations may not be all that clear; it certainly won't be neat;but we can hope thJt it will h;)h~the virtue d being at least p:Jrtly right.

Paul Krugman is a Times Op-Ed colUlT'llist and winner of till! 2/)08 NobellHemorial Prize in EconomicScience. His latest book is 'TIle Rerum of Depres:::ion Econ()Ii'ic~ ar-d the Crisis of 2008."

This article h~s b.~cc ,e\,ised :0 rdlect the fo!io',ving correctioll:

Correction: Sepkmber :). 2009

Because of an editin;r error, a,l ~lrti>:le()!' Page :)6 thi-.;weekend about the failure o~·economists to anticipatethe latest recession l11iSl;,ur)tcsthe l:col1omist ,Jl)l:lJMaynard Keyn~s, \\"ho compared the financiJl markets ofthe t9:3()Sto newspap;,,-r hc;)ul:y 1:\)ntc~;J:sin '" hich rt.:,-'Jers tried til correctly pick all six eventual winners. Mr.Keynf's noted th;lt;] competitor did rot have tl) picl<"tho:::e h'es \\'11jch he himself find~ prettiest but thosethat he thin~s likei;est t) cakb ~he fJnc~.'of the other ccmpditJ,<;.·· He did not S.ly, 'ncr even those that hethinks likeliest to ':cnl...tl:e f..!nc~'of ,)ther competitNs."·