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.

• The Biggest Myths in Economics
• Understanding the Modern Monetary System