How Did Economists Get It So Wrong?

Two eminent economists offer their respective takes on why many economists missed the signs of the impending financial crisis.

First, Nobel-laureate Paul Krugman gives his take. In the September 6th edition of the New York Times Magazine, he argues that much of the blame should be directed toward the theories underlying modern finance, particularly the efficient-market hypothesis:

To be fair, finance theorists didn’t accept the efficient-market hypothesis merely because it was elegant, convenient and lucrative. They also produced a great deal of statistical evidence, which at first seemed strongly supportive. But this evidence was of an oddly limited form. Finance economists rarely asked the seemingly obvious (though not easily answered) question of whether asset prices made sense given real-world fundamentals like earnings. Instead, they asked only whether asset prices made sense given other asset prices. Larry Summers, now the top economic adviser in the Obama administration, once mocked finance professors with a parable about “ketchup economists” who “have shown that two-quart bottles of ketchup invariably sell for exactly twice as much as one-quart bottles of ketchup,” and conclude from this that the ketchup market is perfectly efficient.

Next, over at the National Interest, Barry Eichengreen gives us his view on why many got it wrong (linked to by Greg Mankiw). Eichengreen doesn’t think modern finance theory is to blame, however. He says theory is agnostic; those practicing a “selective reading” of certain financial risk management techniques are really to blame:

[I]t was not that economic theory had nothing to say about the kinds of structural weaknesses and conflicts of interest that paved the way to our current catastrophe. In fact, large swaths of modern economic theory focus squarely on the kind of generic problems that created our current mess. The problem was not an inability to imagine that conflicts of interest, self-dealing and herd behavior could arise, but a peculiar failure to apply those insights to the real world.

Interestingly, while the diagnoses are different, they both come to similar conclusions: less adherence to "elegant" and "neat" financial and economic theories and more realism.

Krugman:

So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. ... [T]hey’ll have to do their best to incorporate the realities of finance into macroeconomics.

Eichengreen:

[T]he twenty-first century will be the age of inductive economics, when empiricists hold sway and advice is grounded in concrete observation of markets and their inhabitants. Work in economics, including the abstract model building in which theorists engage, will be guided more powerfully by this real-world observation. It is about time.

Indeed.