This article is a response to Paul Krugman’s New York Times Magazine article,‘How Did Economists Get It So Wrong?’ Krugman’s attack on modern economics – and many adhominem attacks on modern economists – display a deep and highly politicised ignorance of what economics and finance is really all about, and a striking emptiness of useful ideas.The introductory section reads:
Many friends and colleagues have asked me what I think of Paul Krugman’s New York Times Magazine article, ‘How Did Economists Get It So Wrong?’When he turns to the idea of market efficiency Cochrane makes a point that I'm sure most economists have had to make a some point recently:
Most of all, it is sad. Imagine this were not an economics article. Imagine this were a respected scientist turned popular writer, who says, most basically, that everything everyone has done in his field since the mid-1960s is a complete waste of time. Everything that fills its academic journals, is taught in its PhD programmes, presented at its conferences, summarised in its graduate textbooks, and rewarded with the accolades a profession can bestow (including multiple Nobel Prizes) is totally wrong. Instead, he calls for a return to the eternal verities of a rather convoluted book written in the 1930s, as taught to our author in his undergraduate introductory courses. If a scientist, he might be an AIDS-HIV disbeliever, a creationist or a stalwart that maybe continents do not move after all.
It gets worse. Krugman hints at dark conspiracies, claiming ‘dissenters are marginalised’. The list of enemies is ever growing and now includes ‘new Keynesians’ such as Olivier Blanchard and Greg Mankiw. Rather than source professional writing, he uses out-of-context second-hand quotes from media interviews. He even implies that economists have adopted ideas for pay, selling out for ‘sabbaticals at the Hoover institution’ and fat ‘Wall Street paychecks’.
This approach to economic discourse is a disservice to New York Times readers. They depend on Krugman to read real academic literature and digest it, and they get this attack instead. Any astute reader knows that personal attacks and innuendo mean the author has run out of ideas.
Indeed, this is the biggest and saddest news of this piece: Paul Krugman has no interesting ideas whatsoever about what caused the financial and economic problems that culminated in the crash of 2008, what policies might have prevented it, or what might help us in the future.
But maybe he is right. Occasionally sciences, especially social sciences, do take a wrong turn for a decade or two. I think Keynesian economics was such a wrong turn. So let us take a quick look at the ideas.
Krugman’s attack has two goals. First, he thinks financial markets are inefficient’, fundamentally due to ‘irrational’ investors, and thus prey to excessive volatility which needs government control. Second, he likes the huge ‘fiscal stimulus’ provided by multi-trillion dollar deficits.
It is fun to say that we did not see the crisis coming, but the central empirical prediction of the efficient markets hypothesis is precisely that nobody can tell where markets are going – neither benevolent government bureaucrats, nor crafty hedge-fund managers, nor ivory-tower academics. This is probably the best-tested proposition in all the social sciences. Krugman knows this, so all he can do is rehash his dislike for a theory whose central prediction is that nobody can be a reliable soothsayer. It makes no sense whatsoever to try to discredit efficient market theory in finance because its followers didn't see the crash coming.Cochrane adds:
Krugman writes as if the volatility of stock prices alone disproves market efficiency, and believers in efficient marketers have just ignored it all these years. This is a canard that Krugman should know better than to pass on, no matter how rhetorically convenient. There is nothing about ‘efficiency’ that promises ‘stability’. ‘Stable’ price growth would in fact be a major violation of efficiency as it would imply easy profits.Cochrane then goes on to make another point that economists have to frequently make, and re-make: The case for free markets is not justified by the belief that markets are ‘perfect’
But this argument takes us away from the main point. The case for free markets never was that markets are perfect. The case for free markets is that government control of markets, especially asset markets, has always been much worse.So its not that markets are perfect, its that the alternative is (normally) worse.
On the question of the stimulus, Cochrane writes:
Krugman is a strong supporter of fiscal stimulus. In this quest, he accuses us and the rest of the economics profession of ‘mistaking beauty for truth’. He is not clear on what the ‘beauty’ is that we all fell in love with, and why one should shun it, for good reason. The first siren of beauty is simple logical consistency. Krugman’s Keynesian economics requires that people make logically inconsistent plans to consume more, invest more and pay more taxes with the same income. The second siren is plausible assumptions about how people behave. Keynesian economics requires that the government is able to systematically fool people again and again. It presumes that people don’t think about the future in making decisions today. Logical consistency and plausible foundations are indeed ‘beautiful’ but to me they are also basic preconditions for ‘truth’.Cochrane then says:
In economics, stimulus spending ran aground on Robert Barro’s Ricardian equivalence theorem. This theorem says that debt-financed spending cannot have any more effect than spending financed by raising taxes. People, seeing the higher future taxes that must pay off the debt, will simply save more. They will buy the new government debt and leave all spending decisions unaltered.The question becomes, Does the theorem apply?
Economists have spent a generation tossing and turning the Ricardian equivalence theorem, assessing the likely effects of fiscal stimulus in its light, generalising the ‘ifs’ and figuring out the likely ‘therefores’. This is exactly the right way to do things. The impact of Ricardian equivalence is not that this simple abstract benchmark is literally true. The impact is that in its wake, if you want to understand the effects of government spending, you have to specify why and how it is false.When addressing "the crash" Cochrane writes:
Doing so does not lead you anywhere near old-fashioned Keynesian economics. It leads you to consider distorting taxes, how much people care about their children, how many people would like to borrow more to finance today’s consumption and so on.
For example, most Keynesians think the Ricardian equivalence theorem fails because people don’t rationally anticipate the future taxes that must pay off today’s debt. OK, but what’s good for the goose is good for the gander: if sometimes people pay too little attention to future taxes, at others they pay too much, so stimulus has a negative effect. The latter seems at least plausible now! It is the logically consistent conclusion from Krugman’s views. He thinks deficit concerns are just Tea Party hysteria. OK, but if so, the voters are overestimating future taxes, not ignoring them. Furthermore, if ‘stimulus’ is rooted in people ignoring future taxes, then it makes no sense whatsoever to advocate ‘stimulus’ today but loudly announce the future taxes in ‘deficit reduction’!
Krugman’s New York Times article is supposedly about how the crash and recession changed our thinking, and what economics has to say about it. The most amazing news in the whole article is that Paul Krugman has absolutely no idea about what caused the crash, what policies might have prevented it and what policies we should adopt going forward. He seems completely unaware of the large body of work by economists who actually do know something about the banking and financial system, and have been thinking about it productively for a generation.So, to return to the big question: How did Krugman get it so wrong?
So what is Krugman up to? The only explanation that makes sense to me is that Krugman isn’t trying to be an economist: he is trying to be a partisan, political opinion writer. [...]There is more to the Cochrane article than I have noted here. Get a copy and read, and think about, the whole thing.
To Krugman, economics is no longer a quest for understanding, delightful in its capacity to overturn one’s preconceptions. Economics is just a set of debating points to argue for policies that one has adopted for partisan political purposes. ‘Stimulus’ is just marketing to sell Congressmen and voters a package of government spending priorities that are wants for political reasons. It is not a proposition to be explained, understood, taken seriously to its logical limits, or reflective of market failures that should be addressed directly.