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Panglossian finance

Disagreement among practitioners of the dismal science

As David Blanchflower argued in his first economics column for the NS, the crash of autumn 2008 wasn't just a failure of banking practice -- it was an intellectual failure, too. The collapse of Lehman Brothers just over a year ago wasn't just an indictment of hubris and greed on Wall Street; it was also "a body blow to those economists around the world who had designed worthless mathematical models, based on unrealistic assumptions that they then used to convince themselves that a recession of this kind could never happen again".

Blanchflower's magisterial dismissal of "useless economic models" echoed something the Nobel Prize-winning economist and New York Times columnist Paul Krugman had a written a couple of weeks earlier. Under the title "How Did Economists Get It So Wrong", Krugman chastised economists for "mistaking beauty for truth" -- for allowing themselves, that is, to be seduced by abstract mathematical models and an "idealised vision of an economy in which rational individuals interact in perfect markets". The only problem is that perfect markets have never existed and never will exist -- pace what Krugman nicely calls "Panglossian finance" -- and the sooner economists "learn to live with messiness", the better.

That's a very Keynesian view, of course. As Peter Clarke shows in his book Keynes: the 20th Century's Most Influential Economist (reviewed in the NS by Andrew Gamble), a recognition of the pervasiveness of uncertainty was a very important part of Keynes's vision. Keynes wrote that the "fact that our knowledge of the future is fluctuating, vague and uncertain, renders wealth a peculiarly unsuitable subject for the methods of the classical political economy". In other words, the market doesn't always get it right; in fact, very often it gets it catastrophically wrong.

Compelling stuff -- but some of Krugman's fellow economists have objected to being handed such low marks, among them John H Cochrane of the University of Chicago, who returned fire in an article entitled "How Did Paul Krugman Get It So Wrong?". Cochrane boils Krugman's piece down to the thesis that (in Krugman's own words) "Keynesian economics remains the best framework we have". He then charges Krugman with making a number of incompatible arguments.

For instance, in Cochrane's view, it is only because Krugman caricatures the so-called "efficient markets hypothesis" that his call for an economics that "recognises flaws and frictions" and "incorporates alternative assumptions about behaviour" has any force at all. Cochrane is caustic about this:

I say, "Hello, Paul, where have you been for the last 30 years?" Macroeconomists have not spent 30 years admiring the eternal verities of Kydland and Prescott's 1982 paper. Pretty much all we have been doing for 30 years is introducing flaws, frictions and new behaviours, especially new models of attitudes to risk, and comparing the resulting models, quantitatively, to data. The long literature on financial crises and banking which Krugman does not mention has also been doing exactly the same.

Further, according to Cochrane, "Krugman argues that 'a more or less Keynesian view is the only plausible game in town', and 'Keynesian economics remains the best framework we have for making sense of recessions and depressions'. One thing is pretty clear by now, that when economics incorporates flaws and frictions, the result will not be to rehabilitate an 80-year-old book." Ouch! Cochrane goes on: "A science that moves forward almost never ends up back where it started. Einstein revises Newton, but does not send you back to Aristotle. At best you can play the fun game of hunting for inspirational quotes, but that doesn't mean that you could have known the same thing by just reading Keynes once more."

Cochrane is taking it for granted here that economics is a science, in the way that physics is -- that's the point of the gibe about Einstein, Newton and Aristotle. And I think that may be where the disagreement between Krugman and Cochrane is most profound. For, as Krugman surely knows, Keynes regarded economics as being a moral as much as a mathematical science. This is one of the central insights of Robert Skidelsky's recent book about Keynes, also discussed in the review by Andrew Gamble mentioned above: "One of the greatest defects of economics today is that it has become a branch of applied mathematics. [But] Keynes thought of economics as part of the human discourse."