"The Gratuitous Ignorance of Many of our Economists"

Paul Krugman with more on the failure of academic economics:

Equilibrium decadence (wonkish), by Paul Krugman: Brad DeLong is exercised about William Poole’s technological regress. I was getting at something like the same thing in my Dark Age post. Here are some further thoughts about the sad intellectual history of the past few decades.

What Brad calls technological regress and I call a Dark Age actually began with some profound and productive questioning of conventional wisdom. In the late 1960s macroeconomists began a search for microeconomic foundations — above all, an attempt to explain why nominal shocks seem to have real effects rather than merely affecting the price level. The 1970 Phelps volume, which suggested that imperfect information could explain a lot of what we see, had a huge impact on the profession. And when Lucas married this insight to rational expectations, it seemed to shake the foundations of Keynesian ideas about monetary and fiscal policy. Business cycles, Lucas suggested, last only as long as price- and wage-setters can’t disentangle nominal from real shocks — and monetary or fiscal policy can’t stabilize the economy, at most they add noise.

But it became clear after a few years that this approach wasn’t going to work: actual business cycles last too long to rely on imperfect information. And at that point the profession divided. One group went down the “new Keynesian” route, arguing that something such as small costs of changing prices must explain the rigidity we actually seem to see. This group isn’t averse to putting a lot of rationality into its models, but it’s willing to accept aspects of the world that seem clear in the data, even if it can’t (yet?) be fully explained in terms of deep foundations.

The other group decided that since they couldn’t come up with a rigorous microfoundation for price stickiness, there must not be any price stickiness: recessions are the result of adverse technological shocks, not demand shocks.

And the latter group, the equilibrium macro side, was so convinced of the logical correctness of its position that schools dominated by that view stopped teaching demand-side economics. (Schools dominated by new Keynesians, on the other hand, did teach real business cycle theory.) I haven’t been able to dig up the quote, but somewhere along the line Ed Prescott declared that his students wondered who Keynes was, because he was never mentioned in their courses.

And those trained according to this dogma were and are utterly ignorant of what Keynes, or modern Keynesians, have to say. They know that Keynesianism is stupid nonsense, because that’s what they remember having been told. But they don’t actually know why they’re supposed to believe that; the serious debates the profession had in the 70s about the microfoundations of inflation and unemployment theory are lost in the mist.

And as a result we have the spectacle of well-known economists offering what they think are profound arguments, but are actually long-refuted fallacies. Most important is the “Treasury view” that government spending can’t affect demand. But there’s also the astonishing belief that Ricardian equivalence means that consumer spending automatically falls to offset even a temporary increase in government spending, which seem to be part of that Poole quote. (New Keynesian models in which consumers fully anticipate future taxes still leave room for fiscal policy — but they don’t know that.)

And the sad thing is that all of this matters. Our ability as a nation to respond to the current economic crisis is being seriously hampered by the gratuitous ignorance of many of our economists.

Roman Frydman emails:

In connection with your post of Paul’s text on the failure of economics, Ned Phelps argues this is not about Neo-Keynesians or new Classicals, it is about economics that ignores the key feature of modern economies: the way they unfold over time cannot be represented by fully predetermined models (those modeling the economy with fixed rules implying a single probability distribution for the past and the future).

In fact the problem is the Rational Expectations Hypothesis, which MIT and Chicago happily share. As we argue in "Financial Markets and the State: Price Swings, Risk, and the Scope of Regulation" (and a number of recent academic papers) the mechanical nature of “scientific” models, which economists construct, prevents us from understanding the swings and design of regulatory policies. It is also dangerous, because it may lead to regulation that throws out the baby with the bath water. I think it is time that we leave “the dream of mechanical markets”, something truly difficult for both Paul and Bob Lucas.