"Economics in The Crisis" by Paul Krugman

Why was the economics profession unable to predict the financial crisis? Was the profession missing important historical insights and macroeconomic models?  Furthermore, why were economists conflicted in recommending economic solutions and public policy options? According to Paul Krugman, professor of economics and international affairs at Princeton University and Nobel laureate, the field of economics has much to offer during crises but became politically/socially/geographically divided and forgot basic macroeconomic theory. For example, particular groups of economists forgot important historical lessons from the 1930s, no longer taught basic macroeconomic theory and empirically tested models, and did not observe the changing institutional structure of markets (i.e. shadow banking system and increased leverage). 

PRINCETON - To say the obvious: we’re now in the fourth year of a truly nightmarish economic crisis. I like to think that I was more prepared than most for the possibility that such a thing might happen; developments in Asia in the late 1990s badly shook my faith in the widely accepted proposition that events like those of the 1930s could never happen again. But even pessimists like me, even those who realized that the age of bank runs and liquidity traps was not yet over, failed to realize how bad a crisis was waiting to happen – and how grossly inadequate the policy response would be when it did happen.

And the inadequacy of policy is something that should bother economists greatly – indeed, it should make them ashamed of their profession, which is certainly how I feel. For times of crisis are when economists are most needed. If they cannot get their advice accepted in the clinch – or, worse yet, if they have no useful advice to offer – the whole enterprise of economic scholarship has failed in its most essential duty.

And that is, of course, what has just happened.

In what follows I will talk first about the general role of economics in times of crisis. Then I’ll turn to the specifics of the role economics should have been playing these past few years, and the reasons why it has for the most part not played this role. At the end I’ll talk about what might make things better the next time around.

Crises and Useful Economics

Let me start with a paradox: times of economic disturbance and disorder, of crisis and chaos, are times when economic analysis is especially likely to be wrong. Yet such times are also when economics is most useful.

Why the paradox? Well, first of all, consider what economics can contribute in calm times.

The answer, I’d submit, is surprisingly little. OK, economists can explain why the system works the way it does, and offer useful advice about reforms that would make it better; there’s always use for good microeconomics.

But if you’re trying to make predictions, economists won’t have much to contribute. Take the case of exchange rates, one of my original home areas of research. In ordinary times, it’s very, very hard for structural models to beat a random walk – that is, models based on an attempt to track the forces moving the exchange rate, such as changes in prices and changes in monetary policy, are barely if at all better than the simple guess that tomorrow’s exchange rate will be the same as today’s. And it’s even harder to beat an experienced trader, who has been through many fluctuations and has developed both useful rules of thumb about price patterns and a strong intuitive sense of what comes next.

Economic modelers may be better placed to engage in policy analysis. But even here, experienced practical hands may have the better advice to offer; they know from experience what will soothe the markets, what will rile them, and as long as events remain within the range of their experience, this informal understanding may trump the inevitably simplified and stylized analysis of those who know the world through equations and diagrams.

But now let there be a severe disruption that pushes the economy into terrain experienced practical men have never seen – say, an environment in which credit markets collapse, or short-term interest rates on assets considered safe are pushed all the way to zero. Because there are large and normally unforeseen disruptions, the sheer unpredictability of events will mean many bad economic forecasts, so if you ask how nearly right economists are in their ability to predict events, they will seem to be doing very badly compared with calmer times. But the question you should ask is how economists are doing compared with those who use other ways to understand the world, and in particular how they are doing compared with sober, serious, experienced men in suits. And it is precisely in disturbed times that economists can and sometimes do offer dramatically better predictions and policy judgments than what we normally consider wise men.

Take, for example, the relationship between deficits and interest rates. It’s not an example chosen at random, of course; I believe that it gets to the heart both of the nature of the crisis we’re in and the terrible failure of economists – plus, not incidentally, it happens to be something I personally got right. More about that shortly. But for now, let’s just focus on what we should have known.

Most practical men, confronted with the prospect of unprecedented deficits in the United States, the UK, and elsewhere, extrapolated from their usual experience, in which increased borrowing drives up interest rates. And so there were widespread predictions of sharp rate rises. Most famously, perhaps, Morgan Stanley predicted in late 2009 that interest rates on 10-year US bonds, then around 3.5 percent, would shoot up to 5.5 percent in 2010; in early 2011 Pimco’s legendary head, Bill Gross – who had correctly predicted low rates in 2010 — predicted a rate spike by the summer. And in each case these views were very widely held.

But economists who knew basic macroeconomic theory – specifically, the IS-LM model, which was John Hicks’s interpretation of John Maynard Keynes, and at least used to be in the toolkit of every practicing macroeconomist – had a very different take. By late 2008 the United States and other advanced nations were up against the zero lower bound; that is, central banks had cut rates as far as they could, yet their economies remained deeply depressed. And under those conditions it was straightforward to see that deficit spending would not, in fact, raise rates, as long as the spending wasn’t enough to bring the economy back near full employment. It wasn’t that economists had a lot of experience with such situations (although Japan had been in a similar position since the mid-1990s). It was, rather, that economists had special tools, in the form of models, that allowed them to make useful analyses and predictions even in conditions very far from normal experience.

And those who knew IS-LM and used it – those who understood what a liquidity trap means – got it right, while those with lots of real-world experience were wrong. Morgan Stanley eventually apologized to its investors, as rates not only stayed low but dropped; so, later, did Gross. As I speak, deficits remain near historic highs – and interest rates remain near historic lows.

Crises, then, are times when economics and economists can and should really prove their worth. And I’d like to say that some of my friends and colleagues did; maybe some of them will say that I did OK, too. But one can’t say that of the profession as a whole. On the contrary, all too many of us had rejected the very kinds of analysis that were to prove so useful. And more than that, all too many actively opposed the policy measures the crisis called for.

Actually, let me talk a bit more about the failures of the economics profession in this crisis.

What Should Economists Have Known?

The most common accusation against economists in this crisis is that they failed because they didn’t see it coming. Even the Queen of England has demanded that economists explain their failure to predict the crisis. But I would actually defend my colleagues against assertions that this predictive lapse was, in and of itself, all that much of a failure.

To take the most absurd case, nobody could realistically have demanded that the economics profession predict that Lehman Brothers would go down on September 15, 2008, and take much of the world economy with it. In fact, it’s not reasonable to criticize economists for failing to get the year of the crisis right, or any of the specifics of how it played out, all of which probably depended on detailed contingencies and just plain accident.

What you can criticize economists for – and indeed, what I sometimes berate myself for – is failing even to see that something like this crisis was a fairly likely event. In retrospect, it shouldn’t have been hard to notice the rise of shadow banking, banking that is carried out by non-depository institutions such as investment banks financing themselves through repo. And it shouldn’t have been hard to realize that an institution using overnight borrowing to invest in longer-term and somewhat illiquid assets was inherently vulnerable to something functionally equivalent to a classic bank run – and, furthermore, that the institutions doing this were neither backed by deposit insurance nor effectively regulated. Economists, of all people, should have been on guard for the fallacy of misplaced concreteness, should have realized that not everything that functions like a bank and creates bank-type systemic risks looks like a traditional bank, a big marble building with rows of tellers.

And I plead guilty to falling into that fallacy. I was vaguely aware of the existence of a growing sector of financial institutions that didn’t look like conventional banks, and weren’t regulated like conventional banks, but engaged in bank-like activities. Yet I gave no thought to the systemic risks. (read more)