The Queen of England during the summer asked economists why no one had predicted the credit crunch and recession. Paul Krugman points out that, inasmuch as economists can almost never predict the timing of recessions (and don’t claim to be able to), the real questions are worse. The real questions are, rather how macroeconomists (most) could have gotten it so wrong as to believe that:
(i) a severe recession was not even looming ahead as a potential danger, and
(ii) a breakdown of many of the world’s most liquid financial markets, in New York and London, was impossible to imagine.
To anyone wondering about these questions, I recommend Krugman’s essay in the New York Times Sunday magazine, September 6: “How Did Economists Get it So Wrong?” .
I think his diagnosis of the state of macroeconomic theory for the last 30 years has it right.
I would only add that he is modest in skipping over one point: during Japan’s lost decade of growth in the 1990s Paul himself forcefully drew from the Japanese experience the implication that a severe economic breakdown was, after all, possible in a modern industrialized economy – a breakdown that outside the ken of modern macroeconomic theory and was reminiscent of the Great Depression. But macroeconomics went on as before. (Likewise with the stock market correction of 1987, the LTCM crisis of 1998, and the dotcom bust of 2000-01. I do think, however, that our field did a better job with the emerging market crises of 1994-2001, in part because it was considered permissible to argue that financial markets in this case were highly imperfect.)
The list of scholarly economists who in my view deserve kudos for getting important parts of the crisis right ahead of time also includes, among others:
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Robert Shiller — for declaring most visibly that the housing boom was a bubble,
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Ned Gramlich — for pointing out most assiduously that families were being persuaded to take out mortgages that weren’t good for them,
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Ragu Rajan — for diagnosing most accurately the problems of skewed incentives and excessive leverage in the financial system,
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Claudio Borio and Bill White at the BIS — for seeing most presciently the dangers of a monetary policy that ignored asset bubbles,
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Ken Rogoff, for warning most pithily “This time is not different,” and
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Nouriel Roubini — for forecasting most fortissimo how serious a future meltdown was likely to be.
Returning to Krugman’s NYT article, even the caricature drawings are good… except that I have never seen Olivier Blanchard in a double-breasted suit. But Robert Lucas definitely merits a place there as a leader of the orthodoxy: When given one page in a recent Economist essay to defend “freshwater” economic theorists regarding the crisis, he actually thought it was a useful rebuttal to point out that critics are repeating arguments they have made before. And he also thought it was useful to explain: “The term “efficient” as used here means that individuals use information in their own private interest. It has nothing to do with socially desirable pricing; people often confuse the two.” — As if it is not the latter question that the public is wondering about.
(For other economists’ reactions to the Krugman piece, see the National Journal site.)
[Any reader wishing to make comments on this post is referred to the RGE version.]