Has Economics Failed Us?

In his weekend column Paul Krugman discusses the failure of economics over the last decade.  he says:

“Why, at the moment it was most needed and could have done the most good, did economics fail?

I don’t mean that economics was useless to policy makers. On the contrary, the discipline has had a lot to offer. While it’s true that few economists saw the crisis coming — mainly, I’d argue, because few realized how fragile our deregulated financial system had become, and how vulnerable debt-burdened families were to a plunge in housing prices — the clean little secret of recent years is that, since the fall of Lehman Brothers, basic textbook macroeconomics has performed very well.

But policy makers and politicians have ignored both the textbooks and the lessons of history. And the result has been a vast economic and human catastrophe, with trillions of dollars of productive potential squandered and millions of families placed in dire straits for no good reason.”

This is really two separate questions:

1.  Why didn’t economists see the crisis coming?

2.  Why did economists and policy makers ignore the textbook lessons from economics?

Let’s take a look at both.

Question #1 has a pretty simple answer in my opinion.  Most modern macroeconomists are not market analysts.  They’re not being paid to do what Jan Hatzius does at Goldman Sachs (Hatzius actually did predict the crisis by the way).  Instead, they’re policy analysts.  They work for research institutions, Universities or think tanks and mainly teach and theorize about how to make the world a better place.  But this is an important distinction when thinking about economics and its ability to predict or be used as a device to avoid crisis because the vast majority of “economists” simply aren’t in the macro forecasting game to begin with.  And when they do make real verifiable predictions they’re often so vague that it hardly matters.  

The point is, most economists didn’t predict the crisis because they’re not in the crisis prediction game.  As for the many economists in investment banks and forecasting game – well, I’d say they probably didn’t do a much better job than most other people of predicting the crisis.  That is mainly because predicting the future actions of the madness of crowds is really difficult to do.  But it also doesn’t help that we continue to see so much mythology in economics and that brings us into the answer for question 2.  

On question #2 I would have to disagree with Paul Krugman’s claim that policy makers “ignored both the textbooks and the lessons of history”.   Instead, I would argue that there were several failures stemming directly from economic textbooks:

  • Many people used the textbook model of the money multiplier to make claims about what would happen when the banking system was flooded with reserves (see just about any modern macro econ textbook).
  • Many people used a loanable funds model of the monetary system to construct models for guidance through the crisis (see Mankiw’s Principle of Economics).
  • Many people failed to understand the Euro crisis because they didn’t recognize the difference between being an autonomous currency issuer and being a currency user (another failure of economics textbooks since they don’t even cover such a crucial topic!).

The result of this was widespread confusion about what might happen from QE or what might happen with interest rates and debt levels (see here).  We saw dozens of economists and important policy makers saying excess reserves posed a substantial inflation threat (see here).  We saw Nobel prize winning economists using crude models that implied there would be a “crowding out” effect from the government’s deficit spending (see here).  We saw economists say that a debt crisis could come to the USA because they didn’t understand the distinction between the USA and Europe and how their monetary systems were different (see here).

These were huge failures of modern economics.  And they are the direct result of failed textbook explanations and models of the world that don’t reflect our reality.  Granted, some models performed better, but even Krugman was confused on some of these matters until just a few years ago (such as the case of Europe).  And even his model uses loanable funds which renders it flawed in a world of endogenous money even if it comes to the right conclusions by some chance.

So yes, economics has failed us.  But that’s not because we didn’t listen to the textbooks.  In fact, it’s largely because of the textbooks and their many failures to reflect our monetary reality.

Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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  • LVG

    Good post Cullen. Great links. But you might want to lay off the Krugman bashing. It’s starting to look like you have a man crush.

  • John_S

    I don’t have Krugman’s Macro textbook, but Mankiw’s popular textbook was only updated for the liquidity trap in the last few months. He wrote about the update here:


  • GLG34

    While I am inclined to agree with the thrust of your argument I think it would be short-sighted if we failed to point out that various forms of stimulus were used in the aftermath of the crisis in what can only be judged as a very successful way. We were on the precipice of a full blown repeat of 1929 and here we are 5 years later and it looks like the crisis almost never happened. That’s a remarkable success story if you ask me and not the continual nightmare that lots of people want to portray. And I attribute that largely to the success of the stimulus programs from the Fed and the Treasury. Of course, the US economy is much more dynamic than it was in 1929, but still – this couldn’t have been much deeper, much more prolonged and much worse.

  • The other Matt

    Great stuff Cullen.

    Perhaps just saying the same things you point out, but in my opinion the economics as portrayed by the academics didn’t account, or adjust to, the massive financial engineering that took place over the past 30 years.

    Surely the experts must have recognized the change in finance, but seem to have mostly tried to fit it into their old models. Having finance go from 8% of GDP to 20% while at the same time traditional banking centers went from making 57% of all loans down to 30% wasn’t fully appreciated by the old guard.

  • John_S

    Cullen, slightly off topic, but the latest from Roger Farmer on the Heterodox vs Orthodox debate is great. He gets right to the point on what New Keynesian economics is:

    “New Keynesian economics is a three-equation model that explains the behavior of the nominal interest rate, the “output gap” and the inflation rate.

    I agree firmly with Simon, that from a policy perspective, we should not care one iota if NK economics has anything to do with what Keynes might or might not have thought. But from the perspective of the history of thought, we should not mislead our students with false labels. The New Keynesian model is neither new nor Keynesian. It is a beautiful formalization of David Hume’s verbal argument in his 1742 essay “Of Money”; an early piece on the Quantity Theory of Money that every macroeconomics student should read at least once.”


    That is just begging for you to tear it apart.

  • pliu412

    Economic thoughts have not been labeled as either fiction or nonfiction when publishing in the textbooks or journals. They mix up two concepts: existence and unknown of an economic function/causality as illustrated below.

    F(x,y), A function of two economic variables
    C(x,y), A causality of two economic variables, often required in monetary/fiscal policies

    Nonfictional F(x, y)/C(x,y):
    Existed with unknown or known mathematical properties of F(x, y)/C(x,y)

    Fictional F(x, y)/C(x,y):
    Non-existed with assumed mathematical properties of F(x, y)/C(x,y)

    To answer Questions #1 and #2, the root cause in my opinion is to use fictional F(x, y)/C(x,y) from either textbooks or policy making for real economic condition monitoring or forecasting, and unaware of it.

  • LCaution

    It’s failed because economics and economists are driven by ideology. They construct models, select data and analytical tools, and interpret the results to advance a political agenda: Right or Left.

    That at least is how it appears to this non-economist who can predict with near 100% certainty how any economist will respond to any economic issue solely by knowing for whom the economist works or writes or teaches.

    This endemic bias makes it unreasonable to expect voters or policy makers to do other than follow the recommendations that accord with their ideology.

  • DanH


  • Tom Brown

    Cullen, you write:

    “As for the many economists in investment banks and forecasting game – well, I’d say they probably didn’t do a much better job than most other people of predicting the crisis. That is mainly because predicting the future actions of the madness of crowds is really difficult to do.”

    I’ve recently become a follower of a bog by physicist turned macro-dabbler Jason Smith. Most of his posts have to do with either fitting mainstream models into a framework he’s a fan of called “information transfer economics” or looking at data directly and attempting to explain it in that framework. I still don’t really understand “information transfer economics” well enough to decide if it’s worth while or not, but I think in general he seems to approach the subject with the requisite amount of humility (perhaps unusual for physicist/amateur macro economists?).

    Jason has a recent post on expectations. He’s done a number of posts on this subject. The new one is a little unusual in that it’s attempting to draw conclusions entirely from simulation (not his usual thing: mostly he’s looking at empirical data), but it’s one I could follow the math of pretty well… I think I might even be able to reproduce his results. Anyway, it’s an interesting point he makes… that expectations can destroy information in the market. I don’t expect that this one post, purely about simulation results, proves that, but it’s an interesting idea to me. He also uses this to argue that it’s difficult to do better than the “maximally ignorant” starting point (regarding expectations). Here’s the post:


  • Tom Brown

    Maybe it’s just that I like anything that sounds like it confirms my lazy bias that being “maximally ignorant” is an acceptable strategy. :D

  • Tom Brown

    That’s why I turn to this guy for all my investment advice. :D

  • pliu412

    Your observation is correct from surface. The subtle part is to construct models. Technically and mathematically, they can construct any models they want to support their positions if those models can assume non-existed functions and causalities. My summary of this observation is really derived from recent Cullen’s exposed cases and their used models in terms of mathematical descriptions.

    Validation of “existence/non-existence” property is crucial and needs realistic monetary operation knowledge and/or advanced mathematical and logic analysis capabilities.

    I can understand those capabilities may be outside of economist domain expertise. In this case, we need to reconsider our economics education to include those training since those are persons in positions to make influences to our economic policies in the future.

  • lessismore

    Well, I am not an economist, and I certainly would not be considered qualified to work for the likes of Goldman Sachs, but even I knew something had to give, and I said so to every real estate agent who showed me a house with an unreasonable listing price. What I said was house prices exceeding a certain ratio to wages is unsustainable, and it is foolish to buy a house at such a price. Real estate agents said things like God ain’t making any more land, house prices can only go up, so if you can manage the payments at all, you should buy now. I am still house hunting because even at the so-called “bottom,” the price of the local median house (in my community) is about 8 times the local median wage, so house prices still have not recovered from their sick fever. Meanwhile, my down payment gets bigger and bigger. At this rate, I wonder if reasonable price and my cash will eventually intersect.

  • LCaution

    I’ve been looking for that intersection for longer than I care to say but housing prices (Calif) have always been greater than my income/assets. There was a very brief period last year when it did exist, but I wasn’t paying attention. Houses are now going for S200K – $500K over ask price (even for fixer uppers). One house sold for double the asking price. Flippers bought a house for $550K in Oct., fixed it up very nicely, sold it for 1.2 million last month. Agents tell me a reasonable price is whatever people will pay.

    Is this a bubble? Can any economist say?

  • Bond Vigilante

    - It’s good to see Krugman acknowlegding the amount of household debt matters.
    - Like one C.Roche Krugman still doesn’t understand why the Euro crisis erupted. Fail !!!

  • lessismore

    During the height of the bubble, agents said there was no intrinsic price, and that the price was whatever someone was willing to pay. At the depth of the crash (actually I object to the word crash), there were a lot of gutted houses. It would cost more to fix them than what they could sell for after fixed up, especially those with previous unpermitted “renovations.” Then agents said that the house should have some intrinsic value, at least land value. Sometimes the cost of repairs cut into the land value.

    One house (a one bedroom) in my neighborhood would cost about $300,000 to fix according to the quotes I got. Once fixed it would be worth about $300,000 according to comps. The bank should have given it away, especially since they had actually already made their money back on it. Some guy from Chicago paid $300,000 and then started fixing it up. He is sorry now, because he will never be able to recoup his costs AND he must fix the house because apparently he never knew that the city had the house under enforcement, but now he knows.

  • But What Do I Know?

    Nice analysis, Cullen, but it will take time and more failures for the priests of the old system to recant and be replaced. Keep pushing!

  • http://www.justaluckyfool.wordpress.com justaluckyfool

    Perhaps, maybe a cure.

    SIGNATORIES-Academics: 267+ Countries: 26 Students: 60-Others: 49
    Total number: … Website went live: 24:00 GMT+1, 05/05/14

    The manifesto of 42 networks of economics students from 19 countries
    by Edward Fullbrook

    “Pluralism in thinking is important. The contemporary move towards orthodoxy in economic thinking and the automatic rejection of alternative thinking is a brake on the development of new means of tackling economic and social problems.”
    Frederik Pedersen, Senior Lecturer in Medieval History

    “It’s about time for an initiative like yours. I can only congratulate you. Economics, in its neo-classical version, has been deviated too far from its ethical basis. Economists should, instead, include immaterial values in all their considerations and deliberations.”
    Wolfgang Köhler, Experienced business and financial journalist, Vice- Chair “Finance Watch”, Brussels

    ” This is exactly what I’ve been waiting for.”
    Lorenzo E. Fränkel, Netherlands, University affiliated

    World Economics Association
    Real-World Economics Review
    Connect with us on Facebook
    Follow us on Twitter #changeEconomics

  • PeterP

    Krugman is on a rewriting history spree, mainly to make hinself look good. The track record of his ISLM has been dismal, the model is useless in analyzing balance sheet recessions and that it forecast rates afyer the crisis correctly is a matter of accident. It is important to set the record straight everytime Krugman disses heterodoxy which performed brilliantly compared to his school of econ.

  • Johnny Evers

    Many people saw the housing bubble. Many people recognized the MBS bubble — people on the inside had no incentive to stop what they were doing.
    But nobody learned anything. People still believe that debt is a sacred asset and that the purpose of the economic system is to create financial assets, which can be used to buy things. The financial class got bailed out and is enjoying a nice recovery. In that sense, economics worked.
    Perhaps the failure for economics to be treated seriously is that it has become has become too isolated from all of the other disciplines that affect economics — geology, geography, social sciences, politics (beyond making arguments for more debt).

  • The Other Matt

    The manifesto says: “Change will be difficult – it always is. But it is already happening. Students across the world have already started creating change step by step. We have founded university groups and built networks both nationally and internationally. Change must come from many places. So now we invite you – students, economists, and non-economists – to join us and create the critical mass needed for change.”

    This article originally appeared on guardian.co.uk as posted on http://www.businessinsider.com
    this morning.

    Economics majors around the world are starting to revolt against the status quo of Economic departments.

    Perhaps they’ve been reading Pragcap.com posts!!

  • lessismore

    Here is part of the housing problem, and part of the evidence that a housing recovery means house prices need to fall further in many areas.

    ““Things are improving, but at a snail’s pace,” he said. The NAR points to its “Housing Affordability Index,” which shows that if a U.S. family was earning the median family income in 2013 of $63,623, it would have 175% of the necessary income to buy a median single family home priced at $197,400. (http://www.marketwatch.com/story/many-renters-have-enough-money-to-buy-homes-2014-05-02)

    Affordability must be analyzed in terms of local conditions, not national averages. In my town, agents say, “Buy now. Houses have never been more affordable,” while conveniently overlooking the fact that while local median wages are around $60,000, local median houses are around $600,000.

  • Bond Vigilante

    It seems Krugman needs to change it tune in the near future. There’s a group of students that want to learn about alternative economic theories.

    “The students are revolting”. (Does Krugman has to fear for his job ???).

  • jaymaster

    “Economists tend to think they are much, much smarter than historians, than everybody. And this is a bit too much because at the end of the day, we don’t know very much in economics.

    I think in the social sciences we should all be modest and pragmatic…”

    Thomas Piketty

    He earns some points from me for that!


  • http://orcamgroup.com Cullen Roche

    Interesting to see that he’s never really read Marx also….

  • Bond Vigilante

    Economics a “Social Science” ???

  • Johnny Evers
  • jaymaster

    BV, that’s what I call it. Maybe “soft science” is a better term.

    Others might call it “pseudoscience”….

  • jib

    One thing to remember with established RE markets, especially ones that have had decades of appreciation. There are a lot of people out there that can roll equity into a new house. So it is their mortgage that needs to be 3x their wages, not the house price. I have paid way more than 3x my wages for a house but I have never borrowed more than 3x my wages to buy a house.

    Second point, the median wage worker is not buying a house, they are renting. The median wage of a home buyer in the higher valued markets is more than the median wage of the local economy.

    I am not saying this is be bullish on housing. I am actually quite bearish and considering selling my (paid off) home to move the capital elsewhere and start renting. But RE markets take a long time to clear, a very long time. It might takes decades for it all to work out where you are at and homes to be a bargain again.

  • lessismore

    I am not concerned with getting a “bargain.” I am perfectly willing to pay a fair price. During the bubble, agents said there was no such thing as a fair price, the price is what buyers are willing to pay. Later, during the crash (we desperately need a different word), the same agents insisted that what buyers were willing to pay was not “a fair price.” Buyer’s agents never represent the buyer, no matter what they say.

    On one bank-owned fixer, I made an offer complete with detailed contractor’s quotes for the necessary work, and value of the house after repairs based on comps. The agent representing the bank said he could find a fool who does not do their homework to pay a lot more than what I offered, and sure enough, he did. So much of finance seems to depend on the greater fool theory.