What Went Wrong?

| Thu Sep. 3, 2009 4:27 PM EDT

Paul Krugman writes in the New York Times magazine this week about how economists got everything so wrong.  "As I see it," he says, "the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth."  Brad DeLong puts it this way:

The big lesson, I think, is that Wall Street is much less sophisticated than we imagined it was: Goldman Sachs simply did not do any of the due diligence it needed to do to understand the AIG-specific risks it was assuming, Citigroup was unable to manage its own derivatives book to understand what "liquidity put" risks it was assuming, and as for Bear Stearns, Lehman Brothers, Merrill Lynch — hoo boy...

Oh my, yes.  Wall Street bankers are smart, and rich, and experienced, and knowledgable — but they aren't sophisticated.  They are hairless apes a few gene mutations removed from the savannah who only think they're sophisticated.

So what to do?  Krugman thinks the Great Recession will affect macroeconomics about the same way that black body radiation1 affected physics: it will uproot it completely.  Markets are no longer plausibly efficient, neoclasscial economics plainly doesn't work, and market agents are far more irrational than anyone thinks:

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. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.

Many economists will find these changes deeply disturbing. It will be a long time, if ever, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. To some economists that will be a reason to cling to neoclassicism, despite its utter failure to make sense of the greatest economic crisis in three generations. This seems, however, like a good time to recall the words of H. L. Mencken: “There is always an easy solution to every human problem — neat, plausible and wrong.”

Sounds like a good time to become an economist, if you ask me.  There's work to be done.

1Sorry for the obscure reference, non-science folks.  Max Planck's solution to the black body radiation problem in 1900 was the starting point of quantum mechanics, which uprooted all of classical physics.  See here for more.

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