The state of economics: Krugman is wrong

from Peter Radford

Paul Krugman this morning hammers away at hedge fund managers who, by and large, are complaining about Fed monetary policy, and especially its so-called quantitative easing. The managers are all predicting doom and hyperinflation because of the ongoing ease of Fed policy. It might also have to do with those low interest rates making it harder to earn a living as a hedge manager, but let’s give them the benefit of the doubt. The point is that there are many folks out there who still predict doom based upon the continuance of monetary ease.

Krugman, and others, have long argued that such a view is misguided because an economy mired in the depths – like ours is – does not respond to loose monetary policy the way it would under more ‘normal’ conditions. In particular, no amount of cash whizzing around will cause an inflationary spiral while we are stuck in a liquidity trap. Thus the analysis of the hedge fund managers, which seems to ignore the existence of a liquidity trap, is just wrong and their dire predictions will never be correct.

Case in point: this week’s report that inflation is nonexistent and that consumer prices have edged up only a little over 1% during the last year. Clearly hyperinflation remains a way off. So Krugman’s analysis seems correct, and the hedge fund managers are wrong.

Where I disagree with Krugman in his blog today is his references to the economics profession.

In his discussion this morning he is critical of a defense of the hedge fund managers made by Jesse Eisinger. That defense rests on the notion that economists have no clue about the economy as demonstrated by their inability to predict the bubble and subsequent collapse. There were, of course, many economists who did predict the bubble, but they were not influential enough to have an impact. They remain mostly without influence due to their being outside the profession’s orthodox traditions. Krugman, however, defends the profession against Eisinger’s criticism, and this is where he goes wrong.

It does not matter that some economists were correct. The central orthodoxy of the profession, the source of most advice to policy makers and business people, and the basis of most commonly taught textbooks, totally missed both the possibility and then the existence of  the bubble. Economics was horribly wrong. It hasn’t recovered since. Instead it is stuck in an unproductive self-examination that has yet to have much impact. Those who were wrong still pronounce and influence policy. They continue unabashedly to teach and perpetuate their errors. The profession, such as it is, is splintered into ideological warring camps making no progress towards a newer or more complete understanding of actual economies where things like asset price bubbles can, and evidently do, exist.

In short economics is a mess and is completely deserving of the skepticism Eisinger attributes to the hedge fund managers. After all many of them made fortunes by ignoring economic theory, recognizing the bubble, and shorting sub-prime assets. People who have made fortunes by thinking about the real economy and then risking their assets based upon that thinking, have a right to look down on a bunch of academics who opine about theories whose proof  only ever resides in carefully constructed and highly constrained alternative worlds known as models. To win the respect of hedge fund managers, and anyone else out there in the real world for that matter, academic economists need to demonstrate a commitment to learning from their errors and toss aside erroneous theories. They need to stop regurgitating the same old stuff – some of which dates back to bygone eras and thus predates the development of tour modern economy.

This is not to say, naturally, that old ideas are necessarily wrong. But a social science like economics has to recognize that societies change and that the ‘social’ part of a social science provides the relevant context for the ‘science’ part. Ideas may, therefore, not be timeless. If economists want us to believe they are, then they need to prove that point, and not simply assume it. Economists still are stuck within an anachronistic vision of what they do. They may have stellar reputations as responsible professionals within academia, but, by and large, their relationship with society at large seems amateurish and somewhat naive. Indeed they oftentimes deny its existence, preferring instead to remain engaged in scholarly debate within their respective academic bastions. The point being that economic theory matters, or it ought to matter. People rely on it to inform their decisions. So if theory flounders, so does the profession.

Krugman wants us to believe that economics is still deserving of respect. But what about the current mess within the profession is so deserving? More to the point, and I have argued this before, given the great fractures and ideological splinters within economics, and given the often totally contradictory nature of different economist’s views, on what basis, exactly, does an outsider rest his or her trust? Who do they turn to for reliable advice? And how do they identify an economist’s credentials at all? Where is the professionalism in the profession?

Put it this way: in light of the evident failure of economic orthodoxy in recent years, were you in need of advice regarding the real economy would you turn to an academic economist? Or would you trust your own experience?

Clearly many hedge fund managers and business people choose their own experience. And that says a lot about the state of economics, doesn’t it?