September 6, 2009
How Did Economists Get It So Wrong?By PAUL KRUGMAN
      I. MISTAKING BEAUTY FOR TRUTH
It’s hard to believe now, but not long ago economists werecongratulating themselves over the success of their field. Thosesuccesses — or so they believed — were both theoretical and practical,leading to a golden era for the profession. On the theoretical side,they thought that they had resolved their internal disputes. Thus, in a2008 paper titled “The State of Macro” (that is, macroeconomics, thestudy of big-picture issues like recessions), Olivier Blanchard of M.I.T., now the chief economist at the International Monetary Fund,declared that “the state of macro is good.” The battles of yesteryear,he said, were over, and there had been a “broad convergence of vision.”And in the real world, economists believed they had things undercontrol: the “central problem of depression-prevention has beensolved,” declared Robert Lucas of the University of Chicago in his 2003 presidential address to the American Economic Association. In 2004, Ben Bernanke, a former Princeton professor who is now the chairman of the Federal Reserve Board,celebrated the Great Moderation in economic performance over theprevious two decades, which he attributed in part to improved economicpolicy making.
Last year, everything came apart.
Few economists saw our current crisis coming, but this predictivefailure was the least of the field’s problems. More important was theprofession’s blindness to the very possibility of catastrophic failuresin a market economy. During the golden years, financial economists cameto believe that markets were inherently stable — indeed, that stocksand other assets were always priced just right. There was nothing inthe prevailing models suggesting the possibility of the kind ofcollapse that happened last year. Meanwhile, macroeconomists weredivided in their views. But the main division was between those whoinsisted that free-market economies never go astray and those whobelieved that economies may stray now and then but that any majordeviations from the path of prosperity could and would be corrected bythe all-powerful Fed. Neither side was prepared to cope with an economythat went off the rails despite the Fed’s best efforts.
And in the wake of the crisis, the fault lines in the economicsprofession have yawned wider than ever. Lucas says the Obamaadministration’s stimulus plans are “schlock economics,” and hisChicago colleague John Cochrane says they’re based on discredited“fairy tales.” In response, Brad DeLong of the University of California, Berkeley,writes of the “intellectual collapse” of the Chicago School, and Imyself have written that comments from Chicago economists are theproduct of a Dark Age of macroeconomics in which hard-won knowledge hasbeen forgotten.
What happened to the economics profession? And where does it go from here?
As I see it, the economics profession went astray becauseeconomists, as a group, mistook beauty, clad in impressive-lookingmathematics, for truth. Until the Great Depression,most economists clung to a vision of capitalism as a perfect or nearlyperfect system. That vision wasn’t sustainable in the face of massunemployment, but as memories of the Depression faded, economists fellback in love with the old, idealized vision of an economy in whichrational individuals interact in perfect markets, this time gussied upwith fancy equations. The renewed romance with the idealized marketwas, to be sure, partly a response to shifting political winds, partlya response to financial incentives. But while sabbaticals at the HooverInstitution and job opportunities on Wall Street are nothing to sneezeat, the central cause of the profession’s failure was the desire for anall-encompassing, intellectually elegant approach that also gaveeconomists a chance to show off their mathematical prowess.
Unfortunately, this romanticized and sanitized vision of the economyled most economists to ignore all the things that can go wrong. Theyturned a blind eye to the limitations of human rationality that oftenlead to bubbles and busts; to the problems of institutions that runamok; 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’tbelieve in regulation.
It’s much harder to say where the economics profession goes fromhere. But what’s almost certain is that economists will have to learnto live with messiness. That is, they will have to acknowledge theimportance of irrational and often unpredictable behavior, face up tothe often idiosyncratic imperfections of markets and accept that anelegant economic “theory of everything” is a long way off. In practicalterms, this will translate into more cautious policy advice — and areduced willingness to dismantle economic safeguards in the faith thatmarkets will solve all problems.