Houjun Liu

How Did Economists Get It So Wrong?

A reading: (Krugman 2009)


The discussion here of the conflict between “saltwater” and “freshwater” (Keynesian and Neoclassical) economists is very interesting when evaluated from the perspective of our recent impending recession.

One particular statement that resonated with me in the essay was the fact that a crisis simply “pushed the freshwater economists into further absurdity.” It is interesting to see that, once a theory has been well-established and insulated in a community, it becomes much more difficult to parcel out as something that could be wrong.

As the same time, the forcibly-correcting “fudge” inconsistencies of the Keynesian model is also a strong weakness which perhaps further exacerbated the freshwater economists’ dissent into their models. Modeling human behavior has been consistently quite messy, so it is unsurprising that both neoclassical and Keynesian economists strayed away from those models.

Circling back to the COVID-trigger economic downturn: we definitely see a push towards increased “absurdity” in terms of increased polarization in the US; but not only that, the deeply rooted idea of “pandemics don’t affect the States” or at least “the Feds/our supply chain have preparation for absurd events” is again shown to be false—despite the Obaman re-discovery of Keynesian management earlier.

This all raises a question: under what circumstances is a tangibly “better” result going to surface and be accepted when one model is tangibly perfect yet wrong, the other requiring flawed corrections or unrigorous analysis. Must we reject one model completely before the other one can be used?

I don’t believe behavioral economics, though providing a partial solution as Krugman outlines, is the be-and-end-all of macroeconomic models during a depression. All of the models which were theorized (bar pure neoclassicalist “perfect agents”) ostensibly do one thing: trying to “rationally” model the “irrational” behavior of market participants. I don’t believe that this is ultimately going to be feasible on a macroeconomic scale to create models that will last (sans repeated, empirical testing—but there are not enough depressions to go around.) Perhaps, then, the basic Keynesian idea of simply creating fiscal corrections may very well be the best second thing.

Reading notes

the main problem was the fact that nobody saw a catastrophie coming

More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy.

people either believed that the market would never go wrong or the Fed fixes everything

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.

The economists thought the humans are perfectly rational, and the fact that they are not is what leads to failures

Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts

Keynsian Economics was not trying to entirely replace markets

Keynes did not, despite what you may have heard, want the government to run the economy. … He wanted to fix capitalism, not replace it.

Milton Friedman lead the return to Neoclassical Economics

The neoclassical revival was initially led by Milton Friedman of the University of Chicago, who asserted as early as 1953 that neoclassical economics works well enough as a description of the way the economy actually functions

Neoclassical Economics with the monetarist theory under Milton asserted that keeping the money supply growing is all that needed

Monetarists asserted, however, that a very limited, circumscribed form of government intervention — namely, instructing central banks to keep the nation’s money supply, the sum of cash in circulation and bank deposits, growing on a steady path — is all that’s required to prevent depressions.

Milton Freedman believes that large-scale expansion would lead to inflation and high unimployment

excessively expansionary policies, he predicted, would lead to a combination of inflation and high unemployment

Anti-Keynesian seniments overtook Freedman’s original proposition

Eventually, however, the anti-Keynesian counterrevolution went far beyond Friedman’s position, which came to seem relatively moderate compared with what his successors were saying.

#question why is this obvious?

for obvious reasons

Because the new economists beliefed that the market is right, the advise was for business to max stock price

finance economists believed that we should put the capital development of the nation in the hands of what Keynes had called a “casino.”

Major stock events didn’t blunt the disregard to Keynesian policy

These events, however, which Keynes would have considered evidence of the unreliability of markets, did little to blunt the force of a beautiful idea.

New “perfect” economic models earned large respect in industry

mild-mannered business-school professors could and did become Wall Street rocket scientists, earning Wall Street paychecks.

New models often analyzed financial systems independently of their real-world worth

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

Macro split into two factions: the Keynes recessionists or the anti-Keynesians

macroeconomics has divided into two great factions: “saltwater” economists (mainly in coastal U.S. universities), who have a more or less Keynesian vision of what recessions are all about; and “freshwater” economists (mainly at inland schools), who consider that vision nonsense.

Freshwater economists’ theory: recessions were just people confused?

Nobel laureate Robert Lucas, argued that recessions were caused by temporary confusion: workers and companies had trouble distinguishing overall changes in the level of prices

Under freshwater theories, unemployment is just people electing not to work due to unfavorable environment

amplified by the rational response of workers, who voluntarily work more when the environment is favorable and less when it’s unfavorable. Unemployment is a deliberate decision by workers to take time off.

Put baldly like that, this theory sounds foolish — was the Great Depression really the Great Vacation?

The new Keysians still kept more or less to non-dramatic thinking

They tried to keep their deviations from neoclassical orthodoxy as limited as possible. This meant that there was no room in the prevailing models for such things as bubbles and banking-system collapse.

New Keysians believed entirely in the Fed, without need for large fiscal policy

They believed that monetary policy, administered by the technocrats at the Fed, could provide whatever remedies the economy needed.

People just thought that there can’t be a bubble in housing

What’s striking, when you reread Greenspan’s assurances, is that they weren’t based on evidence — they were based on the a priori assertion that there simply can’t be a bubble in housing.

Obama’s economic policies are much more on the Keynes side

Such Keynesian thinking underlies the Obama administration’s economic policies — and the freshwater economists are furious.

Failure of neoclassicalist theory is that breaking Keynsian economical behavior requires perfect rationality, which is absurd

if you start from the assumption that people are perfectly rational and markets are perfectly efficient, you have to conclude that unemployment is voluntary and recessions are desirable.

Economists thought that economics would have been perfect

Economics, as a field, got in trouble because economists were seduced by the vision of a perfect, frictionless market system.

Behavioral Economics

Behavioral Economics is a study of economics which hinges on the irrationality of human behavior. Its an answer to both the Neoclassical Economics’ poor assumption that humans and markets are perfect, but also Keynsian Economics’s increasingly large need for a random “fudge” to get their models working right.

pillars of Behavioral Economics

  1. “Many real-world investors bear little resemblance to the cool calculators of efficient-market theory: they’re all too subject to herd behavior, to bouts of irrational exuberance and unwarranted panic.”
  2. “even those who try to base their decisions on cool calculation often find that they can’t, that problems of trust, credibility and limited collateral force them to run with the herd.”

Good arbitrageurs are just forced out of the economy in large downward spirals

As a result, the smart money is forced out of the market, and prices may go into a downward spiral.