In Sept 2009, one year after the Lehman Brothers failure, the money market run and commercial paper market freeze, Paul Krugman wrote what he called his "big state-of-economics piece," "How Did Economists Get It So Wrong?" for the Sunday NYT Magazine. Here is a bit:
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 Krugman left out was the division that really mattered, the one between the economists who "got it so wrong" and the economists who got it right.
Indeed, Dirk Bezemer, a name far less familiar than Paul Krugman, had already, with his June 2009 paper, "'No One Saw This Coming': Understanding Financial Crisis Through Accounting Models" (and followed by his September 2009 Financial Times piece, "Why some economists could see the crisis coming"), approached Krugman's question from the opposite direction. Instead of asking why economists got it so wrong, Bezemer studied economists who got it right.
The credit crisis and ensuing recession may be viewed as a ‘natural experiment’ in the validity of economic models. Those models that failed to foresee something this momentous may need changing in one way or another. And the change is likely to come from those models (if they exist) which did lead their users to anticipate instability. The plan of this paper, therefore, is to document such anticipations, to identify the underlying models, to compare them to models in use by official forecasters and policy makers, and to draw out the implications.
There is an immediate link to accounting, organizations and society. Previewing the results, it will be found that ‘accounting’ (or flow-of-funds) models of the economy are the shared mindset of those analysts who worried about a credit-cum-debt crisis followed by recession, before the policy and academic establishment did. They are ‘accounting’ models in the sense that they represent households’, firms’ and governments’ balance sheets and their interrelations. If society’s wealth and debt levels reflected in balance sheets are among the determinants of its growth sustainability and its financial stability, such models are likely to timely signal threats of instability.
In response to Krugmam's NYT Sunday Magazine article, James K. Galbraith, ("Who Are These Economists, Anyway?") pointed out what Krugmam had missed:
Of course, there were exceptions to these trends: a few economists challenged the assumption of rational behavior, questioned the belief that financial markets can be trusted and pointed to the long history of financial crises that had devastating economic consequences. But they were swimming against the tide, unable to make much headway against a per vasive and, in retrospect, foolish complacency.
—Paul Krugman, New York Times Magazine, September 6, 2009
While normal ecclesiastic practice places this word at the end of the prayer, on this occasion it seems right to put it up front. In two sentences, Professor Paul Krugman, Nobel Laureate in Economics for 2008 and in some ways the leading economist of our time, has summed up the failure of an entire era in economic thought, practice, and policy discussion.
And yet, there is something odd about the role of this short paragraph in an essay of over 6,500 words. It ’s a throwaway. It leads nowhere. Apart from one other half-sentence, and three passing mentions of one person, it ’s the only discussion—the one mention in the entire essay—of those economists who got it right. They are not named. Their work is not cited. Their story remains untold. Despite having been right on the greatest economic question of a generation—they are unpersons in the tale.
Krugman’s entire essay is about two groups, both deeply entrenched at (what they believe to be) the top of academic economics. Both are deeply preoccupied with their status and with a struggle for influence and for academic power and prestige—against the other group. Krugman calls them “saltwater” and “freshwater” economists; they tend to call themselves “new classicals” and the “new Keynesians”—although one is not classical and the other is not Keynesian. One might speak of a “Chicago School” and an “MIT School”—after the graduate programs through which so many passed. In truth, there are no precise labels, because the differences between them are both secondary and obscure.
The two groups share a common perspective, a preference for thinking along similar lines. Krugman describes this well, as a “desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.” Exactly so. It was in part about elegance—and in part about showing off. It was not about ... the economy. It was not a discussion of problems, risks, dangers, and policies. In consequence, the failure was shared by both groups. This is the extraordinary thing. Economics was not riven by a feud between Pangloss and Cassandra. It was all a chummy conversation between Tweedledum and Tweedledee. And if you didn’t think either Tweedle was worth much—well then, you weren’t really an economist, were you?
Short excerpts can't do justice, especially to Galbraith's survey of some of those who were right "on the greatest economic question of a generation." I highly recommend the piece be read in its entirety (don't let the publication date fool you -- it's very relevant). I'll include one more short excerpt that is especially relevant and should, in my opinion, be part of all our discussions of government spending, deficits, taxes and non-government saving and debt:
The work of John Maynard Keynes is linked closely to the accounting framework that we call the National Income and Product Accounts. Total product is the flow of expenditures in the economy; the change in that flow is what we call economic growth. The flow of expenditures is broken into major components: consumption, investment, government and net exports, each of them subject to somewhat separable theories about what exactly determines their behavior.
Accounting relationships state definite facts about the world in relational terms. In particular, the national income identity (which simply states that total expenditure is the sum of its components)8 implies, without need for further proof, that there is a reciprocal, offsetting relationship between public deficits and private savings. To be precise, the financial balance of the private sector (the excess of domestic saving over domestic investment) must always just equal the sum of the government budget deficit and the net export surplus. Thus increasing the public budget deficit increases net private savings (for an unchanged trade balance), and conversely: increasing net private savings increases the budget deficit.
The Cambridge (UK) economist Wynne Godley and a team at the Levy Economics Institute have built a series of strategic analyses of the U.S. economy on this insight, warning repeatedly of unsustainable trends in the current account and (most of all) in the deterioration of the private financial balance. They showed that the budget surpluses of the late 1990s (and relatively small deficits in the late 2000s) corresponded to debt accumulation (investment greater than savings) in the private sector. They argued that the eventual cost of servicing those liabilities would force private households into financial retrenchment, which would in turn drive down activity, collapse the corresponding asset prices, and cut tax revenues. The result would drive the public budget deficits through the roof. And thus—so far as the economics are concerned—more or less precisely these events came to pass.
Here are a couple of examples of this kind of analysis by Wynne Godley and L. Randall Wray:
Can Goldilocks Survive? (1999):
Growing government budget surpluses combined with growing trade deficits have generated record private sector deficits. Unless households continue to reduce their saving—creating an increasingly unsustainable debt burden—the impetus that has driven the expansion will evaporate.
Is Goldilocks Doomed? (2000):
…the notion that a federal budget surplus is sustainable, and that it promotes economic growth, must be abandoned. Given the realities of the U.S. trade imbalance, public sector surpluses are consistent with economic growth only so long as the private sector’s financial situation deteriorates at an accelerating pace.
Part of the reason this may be so hard for progressives to wrap our minds around is that not only does it upend conventional wisdom about the role of money, government spending and taxes -- it also requires that we rethink our views regarding the economic "success" of the Clinton administration.
Getting back to the quote from masaccio at the top of the post... The old structures (policy prescriptions from orthodox economists, either saltwater and freshwater) haven't worked and aren't working. Recognizing that is step one. Step two is learning to think away from the formal structures learned in school. Yes, it may be hard... but we are lucky: We have a community of heterodox economists who are in the business of developing a new macroeconomics, who have a track record unmatched by orthodox economists and who want to teach us, all of us -- from Paul Krugman to a random pseudonym on the web -- what they know.
We ordinary citizens have no standing to complain about the blindered and ignorant ideology of our country’s economists and politicians if we are unwilling to take off our own blinders and consider, with an genuinely open mind, these new ideas...
Too much is at stake not to try.
The experts respond to Krugman:
Warren Mosler: comments here.
James Galbraith: comments here.
Rob Parenteau: comments here.
Marshall Auerback comments here and here.
Bill Mitchell comments here and here.
Scott Fullwiler: Paul Krugman—The Conscience of a Neo-Liberal?
Bill Mitchell: Letter to Paul Krugman
(more comments here and please see note below)
Final word from commenter Tom Hickey:
Paul, you didn't cite Jamie's second response back in July.
"Paul, I challenge you to drop the long-term deficit argument entirely -- it will be used in a few months, in a dishonest way by unscrupulous people, to support cuts in Social Security and Medicare that cannot be justified by economic logic. These are cuts which, I am sure, you will oppose when they are proposed. Don't set yourself up."
That was was prescient, since it's exactly what is happening now. The deficit doves are struggling against the onslaught of the deficit doves because they are agreeing that the deficit needs to be cut. MMT shows why their argument is bullocks.
NOTE: This diary is a follow up to my previous post, "Paul Krugman gets it wrong…. Again." and an intro for x-post from MMTer and speaker at last year’s Fiscal Sustainability Teach-In, Pavlina Tcherneva, “Modern Monetary Theory and Mr. Paul Krugman: a way forward”
also x-posted at FDL. From my blog -- selise
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