Economics and Its Discontents

In the aftermath of the worst scare since the 1930s, economists have identified a new culprit to share the blame for the subsequent mess – themselves, or rather those among their tribe with whom they disagree. No longer are greedy Wall Street bankers, feckless regulators and a blasé Federal Reserve Board the only suspects. The economics profession has joined them in the dock.

“How Did Economists Get It So Wrong?” asked Paul Krugman last week in The New York Times Magazine. “The Financial Crisis and the Systemic Failure of the Economics Profession, “ wrote David Colander, Alan Kirman and several others in Critical Review.

“The Other-Worldly Philosophers,” offered the headline of thoughtful examination in The Economist two months ago. On its cover, a textbook – “Modern Economic Theory” – melted into a puddle. The editorial began:

Of all the bubbles that have been pricked, few have burst more spectacularly than the reputation of economics itself.

Is that really true? Or is the hubbub another case of what Sigmund Freud, in Civilization and Its Discontents, termed “the narcissism of small differences” – the tendency to exaggerate the dissimilarities of those who resemble us in an effort to buttress our own self-regard?

Since the controversy is mainly a renewal of hostilities among the New Classical and New Keynesian schools that flared fiercely in the 1970s and ’80s, supplanting the antagonisms among Monetarists and Old Keynesians before settling down to an uneasy backseat truce the ’90s and ’00s (dubbed, if you can believe it, “the new neoclassical synthesis”), there is some reason to suspect that psychopathology is the real problem

The fireworks, as usual, have been provided by Krugman, New York Times columnist, Princeton professor and winner of last year’s economics Nobel Prize.

Forty years ago, he wrote, economics had divided into two great factions, purists and pragmatists, meaning New Classicals and New Keynesians (or freshwater and saltwater economists, in Robert Hall’s memorable phrase, which characterized the neighborhoods of the universities in which the various parties tended to work).

The purists, led by Robert Lucas, Thomas Sargent and Edward Prescott, favored ingeniously-constructed mathematical models, disparaged Keynes, doubted that business cycles can be cured by policy (other than steady monetary growth and credible policy actions to control inflation).

The pragmatists, including Olivier Blanchard, David Romer and N. Gregory Mankiw, inherited from Keynes the belief that market failure is at the center of the business cycle, and built their own style of mathematical models to relate that failure to individual behavior in setting wages and prices. They remained convinced that policy could combat recessions.

Lulled by the success of central bankers Paul Volcker and Alan Greenspan – the quarter-century of steady growth and low inflation over which they presided has been dubbed “the Great Moderation” — the pragmatists gradually abandoned the Old Keynesian faith in activist fiscal policy (although they continued to argue among themselves over whether the smooth sailing stemmed from good monetary policy or from a series of positive developments in the economy itself).

Gradually, even the pragmatists traded their customary wariness for triumphal confidence that monetary policy alone was adequate to tame the business cycle – until last year, when the housing bubble and its counterpart sub-prime crisis gave way to panic when a large investment bank, Lehman Brothers, was allowed to fail. That development, a year ago, took almost all macroeconomists completely by surprise, purists and pragmatists alike.

“Neither side was prepared to cope with an economy that had gone off the rails despite the Federal Reserve Board’s best efforts,” wrote Krugman, though he acknowledged, far down in his article, that policy makers seem to have muddled through. (“Cross your fingers,” he wrote.) For economics itself, he concluded, there was nothing for it now except to admit that, “after several revolutions and counter revolutions, Keynesian economics remains the best framework we have for making sense of recessions and depressions.” The article was accompanied by a series of even more forceful cartoons.

A more temperate version of the same story was offered by Robert J. Gordon, of Northwestern University, earlier this summer at the International Colloquium on History of Thought in Sao Paulo, Brazil. For those interested in the history of the freshwater-saltwater controversy, his account makes fascinating reading.

Gordon offers to relinquish the “Keynesian” adjective to describe the present-day pragmatist (or saltwater tradition) in recognition that this nomenclature was tainted in the ’70s, in large part due to the success of New Classical purists to link it to the failed Phillips Curve, with its one-way tradeoff between unemployment and inflation. Instead, he proposes to substitute “1978-era macro” to describe the pragmatist point of view. A new generation of models, developed to describe supply-side responses to the OPEC shocks as well as traditional demand-side effects, was introduced in two path-breaking intermediate texts that appeared that year, one by Rudiger Dornbush and Stanley Fischer, both of the Massachusetts Institute of Technology, the other by Gordon himself. They contain virtually all the tools necessary to understand the crisis of 2008, he says.

The reasoning is more delicate than Krugman’s article; the survey of the relevant work more even-handed and generous. And he traces some important similarities between the bubbles of 1927-29 and 2003-06. But in the end, Gordon makes the same point as Krugman: to understand what happened in the US during the 2007-09 worldwide crisis, “we are best served by applying 1978-era macro and forgetting most of the modern macro that has developed since.”

He concludes:

Empirical success and common sense have triumphed over the endless search for deep microfoundations in a world in which macroeconomic interactions triumph over individual choice.

He means that wage earners don’t choose to leave their jobs and firms to shut their plants in a recession, in order to enjoy more free time (the caricature implied by purists’ models); instead they are the victims of the coordination failures that occur when financial crashes spill over to the demand for products, and from there to layoffs and unemployment.

That is almost certainly true. But neither is it the whole story. The search for microfoundations may not have turned up much to brag about in the investigation of recessions and unemployment, but it has paid off handsomely in other fields, such as monetary theory and the economics of growth. It may yet tell us something worth knowing about public finance, and even produce a good strong model of the relationship of banking and finance to the real economy. (Almost everyone agrees that’s what’s needed now.) There is no reason to think that the purists should abandon their quest.

But then there is no reason to turn to them for policy advice. For once, there is strong evidence that, with the pragmatists, we’re in good hands. Consider, for example, the performance of the Israeli economy, where arch-pragmatist Stanley Fischer is head of the central bank. A veteran of the Asian and Russian financial crises – during which he was deputy managing director of the International Monetary Fund – Fischer was quick to act when the global economy abruptly stalled last year. He slashed interest rates and conducted a modest competitive devaluation. Now Israel’s export-driven economy is expected to grow by 3.3 percent next year. A single country, yes, but significant as was the performance of the Swedish economy (on similar grounds) in the early 1930s.

More to the point is the current situation in the United States, where another arch- pragmatist, Ben Bernanke, has assumed control, and where the economy apparently is beginning to grow again. Unemployment is still rising; job growth next year is expected to be painfully slow: the recession will go into the record books as the worst since World War II. The seven major economies of Europe are growing again, according to the Organization for Economic Cooperation and Development, as are those of China, India and Russia. On the evidence so far, it is Robert Lucas, not Paul Krugman, who has been more nearly correct: the central problem of depression-prevention apparently has been solved.

By no means is it time to sound the All Clear. But broadly speaking, economics has served us well in understanding and managing the crisis — microeconomics in understanding the myriad mismatched incentives that produced it; battle-tested pagmatic macroeconomics in managing it, so far. Taking the saltwater/freshwater battle back to the pubic won’t help. Freud wrote Civilization and its Discontents in part to explain the persistence of ethnic strife. Never mind the narcissism of small differences. The last thing we need is a civil war in economics’ equivalent of the Balkan states, the fractious province of Macro.

Comments

[socrateazz:]

I may be wrong. I think economists overvalue the short term effects of decisions made to correct imbalances. And they undervalue the consequences of future effects of those decisions. Major economic rules changes since 1980 have been few but really has put us where we are now. In the early eighties, Reagan pushed taxes on higher income people down. Because supply of goods was being overwhelmed by excess wealth going into the workers hands. Those workers attempted to spend that wealth causing a demand which pushed up prices. Inflation was the way of the future at that point. Reagan's policies caused a reversal. Some of those policies needed to be reduced in the 1990's because they were pushing too much wealth into the hands of the few. Instead they were pushed even further toward wealth redistribution toward the rich. Much continues today. Financial controls protected the banks from serious idiotcy for years. They kept banks from making decisions which would be good for the banks short term but had elements which could cause serious imbalances within banks. The problem is: Things which look good short term also have hidden consequences long term. I think we are in the beginings of a depression and I think the short term actions taken so far by those in control will have little positive long term effects. What do I know? Time will tell.

Sep 14 04:27 AM

[CautiousInv...:]

Aware that capitalist systems are inherently unstable and prone to cycles and believing these cycles would play a role in its demise, the spirit of Karl Marx must be glowing in satisfaction knowing that Krugman and others have pretty much dismissed the Austrian school of economics as something quaint and slightly anachronistic; the works of Frederick Hayek and Ludwig Von Mises were not mentioned in the opus on contemporary economic thought.

In light of what has taken place and the failures of the received wisdom offered by the larger schools of economic thought, makes it the more surprising; the Austrian school correctly saw the approaching economic train wreck and presciently anticipates the policies to revive the moribund economy. Whether the S&L crisis, the emerging market crisis, the South American debt crisis, the market crash of 1987, the dot.com crisis or the most recent implosion, the policy response is the same: more liquidity. Had Marx lived at a different time, he would have surely realized the greatest threat to capitalism would be in irresponsible and corrupt fiscal policies and convulsive monetary policy.

“When money creation is sustained, a financial bubble begins to feed on itself, higher prices allowing the owners of inflated titles to spend and borrow more, leading to more credit creation and to even higher prices. As prices get distorted, malinvestments, or investments that should not have been made under normal market conditions, accumulate. Despite this, financial institutions have an incentive to join this frenzy of irresponsible lending, or else they will lose market shares to competitors.

With “liquidities” in overabundance, more and more risky decisions are made to increase yields and leveraging reaches dangerous levels. During that manic phase, everybody seems to believe that the boom will go on. Only the Austrians warn that it cannot last forever, as Friedrich Hayek and Ludwig von Mises did before the 1929 crash, and as their followers have done for the past several years.”

In my mind these two paragraphs offer more insight into the underlying causes of the great recession than do any of the oblique comments offered by either Greenspan or Bernanke. This notwithstanding, Bernanke is has been awarded a second term and is widely regarded as the man who helped avoid total financial collapse. And rather than deal with toxic loans, other malinvestments, structural imbalances, true regulatory reform, improving transparency and scaling down the size banking behemoths, we’ll simply balloon a new bubble.

Sep 14 05:26 AM

[Keithdt:]

Economics is the great voodoo pseudo-science of the current era.

Sep 14 08:03 AM

[Mark Divy:]

Part of the problem is that we have never followed the Keynesian side of economics. China's recent injection of "on hand" capital is really the first chance we have to see what might happen if we really took some of the excess and saved it until there was an economic downturn. I am sure Keynes would not have seen this as the first true test of his theory. We have spent billions during this and previous recessions, but we have never really performed the asset build within the government during the good times to really test the Keynesian side of econimics. Check back in a year or so and then we can compare the actual results of China's recovery with the Keynesian theories.

Sep 14 09:22 AM

[Bjarne Jensen:]

Early in the ‘great depression’ the theory of Business Cycles was discredited by the economic suffering imposed on everyone. Our government was slow to “help” its citizens and the Business Cycle Theory took the hit. I think that is unfortunate because the Business Cycle theory goes a long way to explain the grave economic situation we find ourselves in today.

During the last 25 years the Federal Reserve has administered economic adrenalin three times in order to avoid economic discomfort from a normal business down cycles: They reduced the Fed Funds Rate and flooded the market with cheap money, i.e. a bailout. With each successive bailout the Fed has had to administer ever lower interest rates and provide ever larger sums of borrowed money to achieve the same effect.

The Business Cycle theory contends that business down cycles are essential to a healthy economy; that down cycles should be accepted for their healing properties rather than avoided for their economic pain.

The Business Cycle theory holds that the benefit of down cycles is they force excess debt to be paid down, and unprofitable risky business models to be modified or abandoned. Avoiding down cycles causes borrowers to become addicted to cheap credit and dependent upon excessively leveraged business models. Borrowers, at every level, come to regard debt as wealth, a classic and tragic error of culture and an unsustainable economic model. Without down cycles, debt accumulates and unprofitable excessively risky business models prevail.

When overleveraged banks are bailed out sound banks are punished for their prudence. With each bailout, the failed models, i.e. “bad’ banks gain greater share over prudent profitable banks. After 25 years of handicapping sound financial institutions, essentially every large financial institution in the western world operates on a business model based on extreme leverage of financially engineered products with no “real value”. The world is now burdened with $55-100 trillion of worthless or seriously impaired debt on the balance sheets of virtually every western government, business and citizen. While the value of the assets are impaired the debt remains. And our job situation is structurally weaker from outsourcing, which renders us less capable of servicing that debt. We are over indebted and no longer have the economic means to financially redeem ourselves.

Those 25 years of Fiscal and Monetary Policy have rendered any options left effectively moot: We no longer have sufficient financial, commodity or productive resources of our own to restore prosperity and the cost is greater than the rest of the world is willing to lend us. The Federal Reserve has already begun filling the void by buying Treasuries directly; otherwise known as “printing money”. Printing money has always led to hyperinflation!

Hyperinflation and high unemployment is a tragic combination. An inescapable economic tsunami is on the horizon. The truly unfortunate aspect of the coming tsunami is the magnitude of human suffering that will be left in its wake. I expect that very large portions of the American population will be left homeless, helpless and hungry.

If we continue trying to prop up failed institutions with more borrowed and printed money we will use up the few precious resources we have and go deeper in debt without fixing the problem. By doing more of the same, we risk a depression that we may never recover from. If we have the moral and political courage to accept the economic healing process we will still have a recession but hopefully emerge stronger, growing and vibrant.

1929 clearly showed us that our government can not stand by and do nothing when its citizens are hungry and homeless. However we are at the point in our economic evolution where more bailouts can’t improve our economy; they will only increase the magnitude of economic pain when the adrenalin wears off. Instead of rewarding the culprits, Congress should allow the economic healing process to occur and instead spend the bailout money to lessen the economic burden to its citizens as they suffer through a difficult and painful economic adjustment. Congress can help people weather the recession by providing economic and cultural assistance such as unlimited unemployment insurance, free retraining programs, universal health care, free public transportation, food banks, etc. Consider this, the 3 trillion spent or earmarked to bail out culpable banks is equal to $10,000 for every single person in America. That could go a long way toward getting the economy going again!

Sep 14 10:28 AM

[Mad Hedge F...:]

iiv The dinosaurs of the market, like myself, are collectively being struck by the similarity of the current stock market and that of September 1987, just before the one day, 25% plunge in the Dow. That was when I tied to buy stock with the index down 300 from a payphone in Paris, only to have the trader at Morgan Stanley burst into tears and smash the phone down on the desk (remember that David G.?). My new guru is Gluskin Sheff’s strategist David Rosenberg, who says that stocks have already discounted two years of recovery and now carry a lot of risk. It is priced for 40% EPS growth and a “V” shaped recovery, which we have zero chance of getting. GDP this year will come in at negative 2.5%, and will claw back a listless 1-2% rate in 2010. Stocks are discounting a 4% GDP growth, compared to only 2% for bonds, so he’d much rather own those. With a deflation rate of minus 2% and high yield returns of 12%, junk now offers a 14% inflation adjusted yield, not bad. The secular 25 year bull market in credit expansion is over. Rent still accounts for a third of the CPI, and they are falling for the first time in 17 years. Sure, we’ll see ephemeral sugar highs like those for cash-for-clunkers and the tax credit for first time home buyers. But at best, it will only add up to a series of small “W”’s, or what I refer to the as the “square root” shaped recovery. With the price of everything stretched, you better start reeling in some of that risk.

Sep 14 11:21 AM

[leonb105:]

Jeez, you had me until the last paragraph . . . .


On Sep 14 10:28 AM Bjarne Jensen wrote:

> Early in the ‘great depression’ the theory of Business Cycles was
> discredited by the economic suffering imposed on everyone. Our government
> was slow to “help” its citizens and the Business Cycle Theory took
> the hit. I think that is unfortunate because the Business Cycle
> theory goes a long way to explain the grave economic situation we
> find ourselves in today.
>
> During the last 25 years the Federal Reserve has administered economic
> adrenalin three times in order to avoid economic discomfort from
> a normal business down cycles: They reduced the Fed Funds Rate and
> flooded the market with cheap money, i.e. a bailout. With each successive
> bailout the Fed has had to administer ever lower interest rates and
> provide ever larger sums of borrowed money to achieve the same effect.
>
>
> The Business Cycle theory contends that business down cycles are
> essential to a healthy economy; that down cycles should be accepted
> for their healing properties rather than avoided for their economic
> pain.
>
> The Business Cycle theory holds that the benefit of down cycles is
> they force excess debt to be paid down, and unprofitable risky business
> models to be modified or abandoned. Avoiding down cycles causes
> borrowers to become addicted to cheap credit and dependent upon excessively
> leveraged business models. Borrowers, at every level, come to regard
> debt as wealth, a classic and tragic error of culture and an unsustainable
> economic model. Without down cycles, debt accumulates and unprofitable
> excessively risky business models prevail.
>
> When overleveraged banks are bailed out sound banks are punished
> for their prudence. With each bailout, the failed models, i.e. “bad’
> banks gain greater share over prudent profitable banks. After 25
> years of handicapping sound financial institutions, essentially every
> large financial institution in the western world operates on a business
> model based on extreme leverage of financially engineered products
> with no “real value”. The world is now burdened with $55-100 trillion
> of worthless or seriously impaired debt on the balance sheets of
> virtually every western government, business and citizen. While
> the value of the assets are impaired the debt remains. And our job
> situation is structurally weaker from outsourcing, which renders
> us less capable of servicing that debt. We are over indebted and
> no longer have the economic means to financially redeem ourselves.
>
>
> Those 25 years of Fiscal and Monetary Policy have rendered any options
> left effectively moot: We no longer have sufficient financial, commodity
> or productive resources of our own to restore prosperity and the
> cost is greater than the rest of the world is willing to lend us.
> The Federal Reserve has already begun filling the void by buying
> Treasuries directly; otherwise known as “printing money”. Printing
> money has always led to hyperinflation!
>
> Hyperinflation and high unemployment is a tragic combination. An
> inescapable economic tsunami is on the horizon. The truly unfortunate
> aspect of the coming tsunami is the magnitude of human suffering
> that will be left in its wake. I expect that very large portions
> of the American population will be left homeless, helpless and hungry.
>
>
> If we continue trying to prop up failed institutions with more borrowed
> and printed money we will use up the few precious resources we have
> and go deeper in debt without fixing the problem. By doing more
> of the same, we risk a depression that we may never recover from.
> If we have the moral and political courage to accept the economic
> healing process we will still have a recession but hopefully emerge
> stronger, growing and vibrant.
>
> 1929 clearly showed us that our government can not stand by and do
> nothing when its citizens are hungry and homeless. However we are
> at the point in our economic evolution where more bailouts can’t
> improve our economy; they will only increase the magnitude of economic
> pain when the adrenalin wears off. Instead of rewarding the culprits,
> Congress should allow the economic healing process to occur and instead
> spend the bailout money to lessen the economic burden to its citizens
> as they suffer through a difficult and painful economic adjustment.
> Congress can help people weather the recession by providing economic
> and cultural assistance such as unlimited unemployment insurance,
> free retraining programs, universal health care, free public transportation,
> food banks, etc. Consider this, the 3 trillion spent or earmarked
> to bail out culpable banks is equal to $10,000 for every single person
> in America. That could go a long way toward getting the economy
> going again!

Sep 14 11:53 AM

[Tony Petroski:]

Mr. Warsh: An enjoyable article.

"...Robert J. Gordon, of Northwestern University, earlier this summer at the International Colloquium on History of Thought in Sao Paulo, Brazil."

How do I get that job?


"Gordon offers to relinquish the “Keynesian” adjective to describe the present-day pragmatist (or saltwater tradition) in recognition that this nomenclature was tainted in the ’70s, in large part due to the success of New Classical purists to link it to the failed Phillips Curve, with its one-way tradeoff between unemployment and inflation."

I don't know if I'm a fresh water guy or a salt. I missed that debate. I did sit in on the Phillips curve and I can testify that it had Walter Heller stumped.

"The pragmatists, including Olivier Blanchard, David Romer and N. Gregory Mankiw, inherited from Keynes the belief that market failure is at the center of the business cycle, and built their own style of mathematical models..."

So like the economists. Building mathematical models. I suspect that Freud was closer to the truth than Keynes, micro vs. macro, but poor Keynes was right for the wrong reason.

Sep 14 01:07 PM

[rosey99:]

Adam Smith, widely credited with being the first economist, was no such thing. He was a philosopher. So too are his contemporary brothers and sisters. Am I the only one to notice that an economist's theoretical preferences generally align with their political ideology? Is this as true in physics or chemistry?

The "social sciences" in general are rife with this sort of ideological skew, and a healthy dose of skepticism is required to separate the wheat from the chaff. The increasing popularity of behavioral economics suggests that stronger intellectual foundations are the order of the day. If a theory cannot be proven wrong, it cannot be proven right. Seen this way, most of the conjecture of economics as a discipline falls squarely into the realm of Soros' "fertile fallacy." It's not that it is not useful, but it is definitely not describing something akin to natural law. Caveat emptor, and a large amount of critical thinking will take you a long way.


On Sep 14 08:03 AM Keithdt wrote:

> Economics is the great voodoo pseudo-science of the current era.

Sep 14 01:47 PM

[djackson:]

Interesting read, but I think trying to place what happened in a macro framework fails unless you, potentially, want to attribute part of what created the bubble was monetary policy that was too loose for too long. Much of went wrong was outside what should be construed as macro policy. It involves regulatory failures, poor incentive structures, legal issues such as property rights, etc. These really fall more into microeconomics. And if you say macro saved the day, I'd say it is too soon to pass that judgment.

Sep 14 05:22 PM

[Old Trader:]

There's about as much "science" in the "Dismal Science", as there is in astrology. TPTB would do well to recognize that fact.

Sep 14 07:47 PM

[beach bum ...:]

Dear Mr. Mad Hedge,
You are posting the same comments on every article I read. Why??? Surely you have more to say than "cut" and "paste".

Sep 14 10:16 PM

[Student of ...:]

"Federal Reserve Board’s best efforts..."

These guys are part of the problem, not the solution. A recent article in the Huffington Post, Priceless: How The Federal Reserve Bought The Economics Profession explains just how much of an influence they have (a mild understatement) in what gets published in the journals...

www.huffingtonpost.com...

Sep 15 02:07 AM

[bob adamson:]

The global economy has been experiencing business cycles of increasing intensity and having shorter swing intervals. Over the past 20 plus years these fibulations have struck the economic heart of Latin America, the ‘Tigers” of East Asia, Japan and now the US and EU. While globalization and the information technology revolution have provided many benefits, this growing manic/depressive tendency of economic life is the downside of those developments.

The capacity of nation states to moderate the impact of these swings on both their citizens and economic life generally has been crippled by several factors including the following: excessive deregulation of the banking sector, an major bias against enlarging the public sector to perform functions it is best able to discharge and an increased use of private sector management techniques within the public sector. In short, it has been public policy to place undue reliance on a radical free market private sector model of economic life and subordinate government’s regulatory function and the public sector’s functions to that model.

Until the emergence of this growing manic/depressive tendency became obvious, the role of the business cycle had been undervalued for many years and the predominant view was that monetary or fiscal fine-tuning could do the job (take your pick of short term tools from the ‘bastardized Keynesian’ or the purported Friedman tool kit). Renewed interest in the driving force of uncertainty (as seen by Minsky, Akerloff and others) in shaping and directing investment decisions and therefore the economy helps refocus our perspective. Arguably, the 21st century global economy has been left with few protections and counterbalances to the ebb and flow of tides of private sector market emotion and we need to acknowledge and address this fact decisively but in ways that don’t overshoot the mark.

David Warsh has written an admirable piece describing the evolution of Anglo-American Macroeconomic thinking since WW II and its recent successes and failures. Clearly Macroeconomics analysis is and always will be a work in progress. Rigidity and complacency of thought are the real enemy.

Sep 15 04:00 AM

[American in...:]

Cautious Investor,

Austrian economics is a caricature of how the economy works.

Take the housing bubble, according to the Austrians, it was caused by loose money.

Yet the housing bubble occurred in many countries where monetary policy was quite tight. For example the EU has one monetary policy. Yet Spain and Ireland experienced massive bubbles while France and Germany experienced mild bubbles and other countries in the monetary union experienced virtually none. All of these countries were and are on the Euro. Yet their stories are remarkably different.

So monetary policy is not the whole story or even the most important aspect.

By the way, economists have been struggling for the last 20 years to determine what is the appropriate measure of the money. They've studied dozen of monetary aggregates and most them do not correlate very well with current or future economic activity.


On Sep 14 05:26 AM CautiousInvestor wrote:

> Aware that capitalist systems are inherently unstable and prone to
> cycles and believing these cycles would play a role in its demise,
> the spirit of Karl Marx must be glowing in satisfaction knowing that
> Krugman and others have pretty much dismissed the Austrian school
> of economics as something quaint and slightly anachronistic; the
> works of Frederick Hayek and Ludwig Von Mises were not mentioned
> in the opus on contemporary economic thought.
>
> In light of what has taken place and the failures of the received
> wisdom offered by the larger schools of economic thought, makes it
> the more surprising; the Austrian school correctly saw the approaching
> economic train wreck and presciently anticipates the policies to
> revive the moribund economy. Whether the S&L crisis, the emerging
> market crisis, the South American debt crisis, the market crash of
> 1987, the dot.com crisis or the most recent implosion, the policy
> response is the same: more liquidity. Had Marx lived at a different
> time, he would have surely realized the greatest threat to capitalism
> would be in irresponsible and corrupt fiscal policies and convulsive
> monetary policy.
>
> “When money creation is sustained, a financial bubble begins to feed
> on itself, higher prices allowing the owners of inflated titles to
> spend and borrow more, leading to more credit creation and to even
> higher prices. As prices get distorted, malinvestments, or investments
> that should not have been made under normal market conditions, accumulate.
> Despite this, financial institutions have an incentive to join this
> frenzy of irresponsible lending, or else they will lose market shares
> to competitors.
>
> With “liquidities” in overabundance, more and more risky decisions
> are made to increase yields and leveraging reaches dangerous levels.
> During that manic phase, everybody seems to believe that the boom
> will go on. Only the Austrians warn that it cannot last forever,
> as Friedrich Hayek and Ludwig von Mises did before the 1929 crash,
> and as their followers have done for the past several years.”
>
> In my mind these two paragraphs offer more insight into the underlying
> causes of the great recession than do any of the oblique comments
> offered by either Greenspan or Bernanke. This notwithstanding, Bernanke
> is has been awarded a second term and is widely regarded as the man
> who helped avoid total financial collapse. And rather than deal with
> toxic loans, other malinvestments, structural imbalances, true regulatory
> reform, improving transparency and scaling down the size banking
> behemoths, we’ll simply balloon a new bubble.

Sep 15 07:03 AM

[Hot Richard:]

In the aftermath of the worst scare since the 1930s, politicians have identified new culprits to share the blame for the subsequent mess – themselves, democracy, and Keynes. No longer are greedy Wall Street bankers, feckless capitalists and a blasé economists the only suspects. The professional politician has joined them in the dock along with a couple false gods that enjoy protected status similar to "Mom".

“How Did Politicians Get It So Wrong?” asked...no one. Stay tuned for more of the same.

Kudos to Austrians. Profit from the fools until you are rich and they are broke.

Sep 15 10:24 AM

[carey_jim:]

To repeat myself again, as Yogi Berra used to say over and over, all of our theories and models are approximations and guides for action, just as a map is a guide for navigating through a city and not the city itself.

Quantum mechanics, contrary to popular belief, is one of the best theories ever discovered or invented (depending on your philosophy) because it has never encountered a particle that it can't explain. Unlike economics or psychology, it only needs to describe the actions of a few very well-behaved, simple things called subatomic particles.

The rest of the world is more complicated.

Psychoanalysis, monetarism and Islam (and I chose almost at random) are among the less useful theories we have because they CLAIM to explain almost everything but, in fact, get things wrong at least half the time.

But even though a map of Paris isn't Paris it is still indispensable for navigating around the city.

We shouldn't throw economics out completely, the way we threw out the maps called psychoanalysis, behaviorism and cognitive psychology (etc.) just because they all got about fifty percent of what they were supposed to explain, wrong.

Psychiatry has rejected psychotherapy almost completely and embraced pills as the cure of every mental ill. Let's hope that the economics profession doesn't reject economics completely and replace it with the socialist pill, Government Can Solve All Of Our Problems.

We need our models and maps even though they often don't work, or sometimes only help us with small parts of the problems we are trying to solve.

The first law of finance should be: When you reach a fork in the road, take it, or at least use it to eat dinner or dig yourself out of a hole.

Sep 15 12:30 PM

[Paul Harper:]

On Sep 15 07:03 AM American in Paris wrote:
Take the housing bubble, according to the Austrians, it was caused
by loose money.
Yet the housing bubble occurred in many countries where monetary
policy was quite tight. For example the EU has one monetary policy.
Yet Spain and Ireland experienced massive bubbles while France and
Germany experienced mild bubbles and other countries in the monetary union experienced virtually none.

With regards to this part of your comment, I think we have to take social economics into consideration.
Whereas in Ireland, Spain & UK, householders expect to be exactly that, in Northern Europe & France, most city dwellers still rent, there is not the same level of peeer pressure to be on the property ladder.
A non EU example is Switzerland, where more than 60% of the population are renters. (speak from personal experience here)

Sep 16 07:30 AM