I. MISTAKING BEAUTY FOR TRUTH
Skip to next paragraph     Enlarge This Image
Jason Lutes


  MultimediaGraphic
Graphic

RelatedLetters: How Did Economists Get It So Wrong? (September 20, 2009) Go to Columnist Page » Blog: The Conscience of a Liberal

  Enlarge This Image
Jason Lutes


  

It’s hard to believe now, butnot long ago economists were congratulating themselves over the successof their field. Those successes — or so they believed — were boththeoretical and practical, leading to a golden era for the profession.On the theoretical side, they thought that they had resolved theirinternal disputes. Thus, in a 2008 paper titled “The State of Macro”(that is, macroeconomics, the study of big-picture issues likerecessions), 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.
Feweconomists saw our current crisis coming, but this predictive failurewas 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 inthe wake of the crisis, the fault lines in the economics professionhave yawned wider than ever. Lucas says the Obama administration’sstimulus plans are “schlock economics,” and his Chicago colleague JohnCochrane 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?
AsI see it, the economics profession went astray because economists, as agroup, mistook beauty, clad in impressive-looking mathematics, fortruth. 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 economy led mosteconomists to ignore all the things that can go wrong. They turned ablind eye to the limitations of human rationality that often lead tobubbles and busts; to the problems of institutions that run amok; tothe imperfections of markets — especially financial markets — that cancause the economy’s operating system to undergo sudden, unpredictablecrashes; and to the dangers created when regulators don’t believe inregulation.
It’s much harder to say where the economicsprofession goes from here. But what’s almost certain is that economistswill have to learn to live with messiness. That is, they will have toacknowledge the importance of irrational and often unpredictablebehavior, face up to the often idiosyncratic imperfections of marketsand accept that an elegant economic “theory of everything” is a longway off. In practical terms, this will translate into more cautiouspolicy advice — and a reduced willingness to dismantle economicsafeguards in the faith that markets will solve all problems.
II. FROM SMITH TO KEYNES AND BACK
The birth of economics as a discipline is usually credited toAdam Smith, who published “The Wealth of Nations” in 1776. Over thenext 160 years an extensive body of economic theory was developed,whose central message was: Trust the market. Yes, economists admittedthat there were cases in which markets might fail, of which the mostimportant was the case of “externalities” — costs that people impose onothers without paying the price, like traffic congestion or pollution.But the basic presumption of “neoclassical” economics (named after thelate-19th-century theorists who elaborated on the concepts of their“classical” predecessors) was that we should have faith in the marketsystem.
This faith was, however, shattered by the GreatDepression. Actually, even in the face of total collapse someeconomists insisted that whatever happens in a market economy must beright: “Depressions are not simply evils,” declared Joseph Schumpeterin 1934 — 1934! They are, he added, “forms of something which has to bedone.” But many, and eventually most, economists turned to the insightsof John Maynard Keynes for both an explanation of what had happened and a solution to future depressions.
Keynesdid not, despite what you may have heard, want the government to runthe economy. He described his analysis in his 1936 masterwork, “TheGeneral Theory of Employment, Interest and Money,” as “moderatelyconservative in its implications.” He wanted to fix capitalism, notreplace it. But he did challenge the notion that free-market economiescan function without a minder, expressing particular contempt forfinancial markets, which he viewed as being dominated by short-termspeculation with little regard for fundamentals. And he called foractive government intervention — printing more money and, if necessary,spending heavily on public works — to fight unemployment during slumps.