The economist John Maynard Keynes wrote The General Theory of Employment, Interest, and Money (1936) to “bring to an issue the deep divergences of opinion between fellow economists which have for the time being almost destroyed the practical influence of economic theory.”
Seventy years later, heavyweight economists are still at each other’s throats, in terms almost unchanged from the 1930s.
The latest slugfest features New Keynesian champion Paul Krugman of Princeton University and New Classical champion John Cochrane of the University of Chicago. Krugman recently published a newspaper article entitled “How Did Economists Get It So Wrong?”
There was nothing in mainstream economics, Krugman wrote, “suggesting the possibility of the kind of collapse that happened last year.”
The reason was that “economists, as a group, mistook beauty, clad in impressive-looking math, for truth.” They purveyed an “idealized vision of an economy in which rational individuals interact in perfect markets.” Unfortunately “this sanitized vision of the economy led most economists to ignore all the things that could go wrong.”
So now, economists will have to accept “the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic ‘theory of everything’ is a long way off.”
Krugman’s heavy pounding of Chicago School economics goaded Cochrane, a professor of finance, into some bad-tempered counter-punching on the university’s Web site, much of which consisted of a personal attack on Krugman’s scientific integrity.
When he gets around to economics, Cochrane aims his blows at two points: Krugman’s attack on the “efficient market theory” and his advocacy of “fiscal stimulus” for depressed economies.
Cochrane accuses Krugman of misleading his readers about the efficient market theory, which asserts that, given the available information, financial markets always get asset prices right. Rather than defend that theory, Cochrane admits that “asset prices move more than reasonable expectations of future cash flows.” Unfortunately, “no theory is particularly good at that right now.”
But it is theoretical nihilism, Cochrane argues, to ascribe these excessive fluctuations to “irrationality,” as Krugman does. What Krugman is really after (“though he can’t quite come out and say this”) is for the government to “take charge of the allocation of capital.” And the one thing we do know is that however badly asset markets behave, government control “has always been much worse.”
Cochrane’s heaviest punching is reserved for Krugman’s support for US President Barack Obama’s fiscal stimulus. He invokes the hoary old “Ricardian equivalence theorem,” revived by the Harvard economist Robert Barro, according to whom “debt-financed spending can’t have any effect, because people, seeing the higher future taxes that must pay off the debt, will simply save more. They will buy the new government debt and leave all spending decisions unaltered.”
In short, Krugman “has absolutely no idea about what caused the crash, what policies might have prevented it, and what policies we should adopt going forward” — except that the government should now spend money like a drunken sailor. Far from having too much math, economists need more in order to “keep the logic straight.”
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