VII. FLAWS AND FRICTIONS
Economics, as a field, got in trouble because economists wereseduced by the vision of a perfect, frictionless market system. If theprofession is to redeem itself, it will have to reconcile itself to aless alluring vision — that of a market economy that has many virtuesbut that is also shot through with flaws and frictions. The good newsis that we don’t have to start from scratch. Even during the heyday ofperfect-market economics, there was a lot of work done on the ways inwhich the real economy deviated from the theoretical ideal. What’sprobably going to happen now — in fact, it’s already happening — isthat flaws-and-frictions economics will move from the periphery ofeconomic analysis to its center.
There’s already a fairly well developed example of the kind ofeconomics I have in mind: the school of thought known as behavioralfinance. Practitioners of this approach emphasize two things. First,many real-world investors bear little resemblance to the coolcalculators of efficient-market theory: they’re all too subject to herdbehavior, to bouts of irrational exuberance and unwarranted panic.Second, even those who try to base their decisions on cool calculationoften find that they can’t, that problems of trust, credibility andlimited collateral force them to run with the herd.
On the first point: even during the heyday of the efficient-markethypothesis, it seemed obvious that many real-world investors aren’t asrational as the prevailing models assumed. Larry Summers once began apaper on finance by declaring: “THERE ARE IDIOTS. Look around.” Butwhat kind of idiots (the preferred term in the academic literature,actually, is “noise traders”) are we talking about? Behavioral finance,drawing on the broader movement known as behavioral economics, tries toanswer that question by relating the apparent irrationality ofinvestors to known biases in human cognition, like the tendency to caremore about small losses than small gains or the tendency to extrapolatetoo readily from small samples (e.g., assuming that because home pricesrose in the past few years, they’ll keep on rising).
Until the crisis, efficient-market advocates like Eugene Famadismissed the evidence produced on behalf of behavioral finance as acollection of “curiosity items” of no real importance. That’s a muchharder position to maintain now that the collapse of a vast bubble — abubble correctly diagnosed by behavioral economists like Robert Shillerof Yale, who related it to past episodes of “irrational exuberance” —has brought the world economy to its knees.
On the second point: suppose that there are, indeed, idiots. Howmuch do they matter? Not much, argued Milton Friedman in an influential1953 paper: smart investors will make money by buying when the idiotssell and selling when they buy and will stabilize markets in theprocess. But the second strand of behavioral finance says that Friedmanwas wrong, that financial markets are sometimes highly unstable, andright now that view seems hard to reject.
Probably the most influential paper in this vein was a 1997publication by Andrei Shleifer of Harvard and Robert Vishny of Chicago,which amounted to a formalization of the old line that “the market canstay 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 depletethat capital. As a result, the smart money is forced out of the market,and prices may go into a downward spiral.
The spread of the current financial crisisseemed almost like an object lesson in the perils of financialinstability. And the general ideas underlying models of financialinstability have proved highly relevant to economic policy: a focus onthe depleted capital of financial institutions helped guide policyactions taken after the fall of Lehman, and it looks (cross your fingers) as if these actions successfully headed off an even bigger financial collapse.
Meanwhile, what about macroeconomics? Recent events have prettydecisively refuted the idea that recessions are an optimal response tofluctuations in the rate of technological progress; a more or lessKeynesian view is the only plausible game in town. Yet standard NewKeynesian models left no room for a crisis like the one we’re having,because those models generally accepted the efficient-market view ofthe financial sector.
There were some exceptions. One line of work, pioneered by none other than Ben Bernanke working with Mark Gertler of New York University,emphasized the way the lack of sufficient collateral can hinder theability of businesses to raise funds and pursue investmentopportunities. A related line of work, largely established by myPrinceton colleague Nobuhiro Kiyotaki and John Moore of the LondonSchool of Economics, argued that prices of assets such as real estatecan suffer self-reinforcing plunges that in turn depress the economy asa whole. But until now the impact of dysfunctional finance hasn’t beenat the core even of Keynesian economics. Clearly, that has to change.
VIII. RE-EMBRACING KEYNES
So here’s what I think economists have to do. First, they have toface up to the inconvenient reality that financial markets fall farshort of perfection, that they are subject to extraordinary delusionsand the madness of crowds. Second, they have to admit — and this willbe very hard for the people who giggled and whispered over Keynes —that Keynesian economics remains the best framework we have for makingsense of recessions and depressions. Third, they’ll have to do theirbest to incorporate the realities of finance into macroeconomics.
Many economists will find these changes deeply disturbing. It willbe a long time, if ever, before the new, more realistic approaches tofinance and macroeconomics offer the same kind of clarity, completenessand sheer beauty that characterizes the full neoclassical approach. Tosome economists that will be a reason to cling to neoclassicism,despite its utter failure to make sense of the greatest economic crisisin three generations. This seems, however, like a good time to recallthe words of H. L. Mencken: “There is always an easy solution to everyhuman problem — neat, plausible and wrong.”
When it comes to the all-too-human problem of recessions anddepressions, economists need to abandon the neat but wrong solution ofassuming that everyone is rational and markets work perfectly. Thevision that emerges as the profession rethinks its foundations may notbe all that clear; it certainly won’t be neat; but we can hope that itwill have the virtue of being at least partly right.
Paul Krugman is a Times Op-Edcolumnist and winner of the 2008 Nobel Memorial Prize in EconomicScience. His latest book is “The Return of Depression Economics and theCrisis of 2008.”

This article has been revised to reflect the following correction:
Correction: September 6, 2009
Because of an editing error, an article on Page 36 this weekendabout the failure of economists to anticipate the latest recessionmisquotes the economist John Maynard Keynes,who compared the financial markets of the 1930s to newspaper beautycontests in which readers tried to correctly pick all six eventualwinners. Keynes noted that a competitor did not have to pick “thosefaces which he himself finds prettiest, but those that he thinkslikeliest to catch the fancy of the other competitors.” He did not say,“nor even those that he thinks likeliest to catch the fancy of othercompetitors.”