Stiglitz on the need for a new economic paradigm

The standard macroeconomic models have failed, by all the most important tests of scientific theory. They did not predict that the financial crisis would happen; and when it did, they understated its effects. Monetary authorities allowed bubbles to grow and focused on keeping inflation low, partly because the standard models suggested that low inflation was necessary and almost sufficient for efficiency and growth. After the crisis broke, policymakers relying on the models floundered. Notwithstanding the diversity of macroeconomics, the sum of these failures points to the need for a fundamental re-examination of the models—and a reassertion of the lessons of modern general equilibrium theory that were seemingly forgotten in the years leading up to the crisis.

See the Stigliz contribution in the Financial Times web site.

Lucas in Defence of the Dismal Science

One thing we are not going to have, now or ever, is a set of models that forecasts sudden falls in the value of financial assets, like the declines that followed the failure of Lehman Brothers in September. This is nothing new. It has been known for more than 40 years and is one of the main implications of Eugene Fama’s “efficient-market hypothesis” (EMH), which states that the price of a financial asset reflects all relevant, generally available information. If an economist had a formula that could reliably forecast crises a week in advance, say, then that formula would become part of generally available information and prices would fall a week earlier. (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.)

The Economist’s briefing also cited as an example of macroeconomic failure the “reassuring” simulations that Frederic Mishkin, then a governor of the Federal Reserve, presented in the summer of 2007. The charge is that the Fed’s FRB/US forecasting model failed to predict the events of September 2008. Yet the simulations were not presented as assurance that no crisis would occur, but as a forecast of what could be expected conditional on a crisis not occurring. Until the Lehman failure the recession was pretty typical of the modest downturns of the post-war period. There was a recession under way, led by the decline in housing construction. Mr Mishkin’s forecast was a reasonable estimate of what would have followed if the housing decline had continued to be the only or the main factor involved in the economic downturn. After the Lehman bankruptcy, too, models very like the one Mr Mishkin had used, combined with new information, gave what turned out to be very accurate estimates of the private-spending reductions that ensued over the next two quarters. When Ben Bernanke, the chairman of the Fed, warned Hank Paulson, the then treasury secretary, of the economic danger facing America immediately after Lehman’s failure, he knew what he was talking about.

Mr Mishkin recognised the potential for a financial crisis in 2007, of course. Mr Bernanke certainly did as well. But recommending pre-emptive monetary policies on the scale of the policies that were applied later on would have been like turning abruptly off the road because of the potential for someone suddenly to swerve head-on into your lane. The best and only realistic thing you can do in this context is to keep your eyes open and hope for the best.

For the full Lucas contribution see The Economist web page

Marshall on The Ordinary Business of Life

"Political Economy or Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of well being." Alfred Marshall, Principles of Economics, 1890.

Smith on the Invisible Hand

"...every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.", Adam Smith, The Wealth of Nations, 1776.

Ricardo on Comparative Advantage

"To produce the wine in Portugal, might require only the labour of 80 men for one year, and to produce the cloth in the same country, might require the labour of 90 men for the same time. It would therefore be advantageous for her to export wine in exchange for cloth. This exchange might even take place, notwithstanding that the commodity imported by Portugal could be produced there with less labour than in England. Though she could make the cloth with the labour of 90 men, she would import it from a country where it required the labour of 100 men to produce it, because it would be advantageous to her rather to employ her capital in the production of wine, for which she would obtain more cloth from England, than she could produce by diverting a portion of her capital from the cultivation of vines to the manufacture of cloth." David Ricardo, Principles of Political Economy and Taxation, 1817.

What Went Wrong with Economics

OF ALL the economic bubbles that have been pricked, few have burst more spectacularly than the reputation of economics itself. A few years ago, the dismal science was being acclaimed as a way of explaining ever more forms of human behaviour, from drug-dealing to sumo-wrestling. Wall Street ransacked the best universities for game theorists and options modellers. And on the public stage, economists were seen as far more trustworthy than politicians. John McCain joked that Alan Greenspan, then chairman of the Federal Reserve, was so indispensable that if he died, the president should “prop him up and put a pair of dark glasses on him.” In the wake of the biggest economic calamity in 80 years that reputation has taken a beating. In the public mind an arrogant profession has been humbled. Though economists are still at the centre of the policy debate—think of Ben Bernanke or Larry Summers in America or Mervyn King in Britain—their pronouncements are viewed with more scepticism than before. The profession itself is suffering from guilt and rancour. In a recent lecture, Paul Krugman, winner of the Nobel prize in economics in 2008, argued that much of the past 30 years of macroeconomics was “spectacularly useless at best, and positively harmful at worst.” Barry Eichengreen, a prominent American economic historian, says the crisis has “cast into doubt much of what we thought we knew about economics.” In its crudest form—the idea that economics as a whole is discredited—the current backlash has gone far too far. If ignorance allowed investors and politicians to exaggerate the virtues of economics, it now blinds them to its benefits. Economics is less a slavish creed than a prism through which to understand the world. It is a broad canon, stretching from theories to explain how prices are determined to how economies grow. Much of that body of knowledge has no link to the financial crisis and remains as useful as ever. And if economics as a broad discipline deserves a robust defence, so does the free-market paradigm. Too many people, especially in Europe, equate mistakes made by economists with a failure of economic liberalism. Their logic seems to be that if economists got things wrong, then politicians will do better. That is a false—and dangerous—conclusion. (from The Economist, Jul 16th 2009.)

Keynes on The Ideas of Economists

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” John Maynard Keynes, The General Theory of Employment, Interest and Money, 1936.