Krugman on the Future of Economics
September 3rd, 2009I have long had an interest in what the financial crisis means for the future of the fields of economics and finance (see Future of Financial Economics and Future of Financial Economics Part Deux). So I was incredibly pleased to come across Krugman’s abbreviated history and thoughtful criticisms of the field of economics in the New York Times Magazine (see How Did Economists Get It So Wrong).
A bit of a teaser:
Last year, everything came apart.
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.
What happened to the economics profession? And where does it go from here?
As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth…the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.
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.
Krugman follows that introduction with a fascinating, and well-informed, account of the history and development of the field of economics, with a focus on macroeconomics/finance and the longstanding debate between so-called freshwater (Free-Market) economists and saltwater (Keynseyian) economists. Although Krugman and I are in different academic fields (Krugman is an international macro scholar and I am an international business strategy scholar), our conclusions with respect to the future of financial economics are more or less aligned. Krugman suggests:
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 [economics].
Krugman’s article is a fairly long (hence its placement in the magazine), but well worth your time to read. So carve out a bit of time, visit the NY Times Magazine website, pour yourself a drink, and enjoy the read.
