Krugman: Getting Economists Wrong
Paul Krugman's essay in yesterday's New York Times magazine has me puzzled. Specifically, I think the longstanding divide between the "freshwater" (i.e. Chicago and Minnesota) and "saltwater" (e.g., Harvard, MIT, Princeton, Stanford and other coastal universities) schools of macroeconomics is of little relevance to an explanation of "How Did Economists Get It So Wrong?" Here is what Krugman claims that economists got wrong:
Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy. During the golden years, financial economists came to believe that markets were inherently stable — indeed, that stocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year. Meanwhile, macroeconomists were divided in their views. But the main division was between those who insisted that free-market economies never go astray and those who believed that economies may stray now and then but that any major deviations from the path of prosperity could and would be corrected by the all-powerful Fed. Neither side was prepared to cope with an economy that went off the rails despite the Fed’s best efforts.
I spend a lot of time with economists. I haven't met one who was "blind to the very possibility of catastrophic failures in a market economy." I also haven't met one who insists that "stocks and other assets were always priced just right." Speaking for myself, I misunderstood two things about financial markets:
1) I had no idea that the major ratings agencies like Moody's and S&P were in on the con. I thought they made their money by preserving their reputations for honest assessments above all else. Many elements of financial innovation and regulation were dependent on a AAA rating being a AAA rating. If you would have shown most economists I know that the ratings were bogus, or if you had even convinced them that the ratings were being paid for by the sellers of the securities, not the buyers, then basic economic theory would have suggested that the problems of biased ratings would have been severe. In other words, this was not a failure of economic theory. The failure was empirical -- we mistakenly believed that risky assets were being appropriately classified.
2) I had too little appreciation for the way ex ante distinctions -- like whether a financial institutions liabilities were federally insured -- would be of little relevance in the way the government dealt with the potential insolvency of financial institutions. If we were going to bail out Bear Stearns, AIG, and through them, Government Sachs and the rest, then we should have been regulating them much more tightly and charging them insurance premiums. I thought that uninsured and unregulated meant that the public trough was closed. I was wrong. Had I realized this earlier, I would have been much more concerned about the goings-on in financial markets than I previously was.
Krugman's essay is written as if the failure of economists was a failure of the profession to correctly advise policy makers on what to do, either before the financial crisis or during and after the recession. I don't see the policy advice being given to recent Presidents as being too tainted by this controversy. The Chicago School may not be of much help in getting out of the recession quickly, but neither has it been at the center of policy making. Consider the recent members of the Council of Economic Advisers -- there is hardly a Chicago-school devotee in the mix. Presidents over the last two decades have been getting their advice from academic economists who generally believe that the government has a role to play in making up for weak demand during a recession. If we failed to provide good advice, it has nothing to do with our profession's internal disagreements.
Let's Be Honest
What pasty, weasly reasoning. So you didn't know the ratings were wrong. If you understood anything about structured finance and off- balance sheet banking you should have known no one could value pools of sliced and diced assets under extreme dysfunctional circumstances, like subprime lending blowing up.
So you didn't grasp that financial regulation wasn't working as you expected. The legal changes that undercut banking and mortgage regulation went right by your desk (well, they were at least public) and were well understood by both banks and the regulators as the Rube Goldberg Risk Transfer Empire was being constructed. Once it had been setup, no one should be surprised that a couple of poor suckers like AIG and Lehman held mostly looser bets. Everyone knew that trillions had been bet and that someone would have to pay when it all came due. None of that was secret. Too big to fail is not new.
Indeed, all you really had to know was how to calculate leverage ratios.
This does not reflect well on you.
"1) I had no idea that the major ratings agencies like Moody's and S&P were in on the con."
That sounds like you were fantastically naive. Anyone who has ever paid for an appraisal knows that the appraiser wants to please the guy who signs the check. They'll often flat out ask you whether you want them to reach high or reach low. Since Moody's and S&P were in competition, they were under serious competitive pressure to provide the desired numbers, lest their rival get an advantage.
"2) I had too little appreciation for the way ex ante distinctions -- like whether a financial institutions liabilities were federally insured -- would be of little relevance in the way the government dealt with the potential insolvency of financial institutions."
That sounds like you were ingenuous. Surely you remember, at least vaguely, what happened in the last several financial collapses. The government basically does a bail out applying its full faith and credit to keep the wheels turning. When was the last time the FDIC enforced its $100,000 limit on a white owned bank? Why should the government's handling of this most recent failure be even slightly different from the previous ones?
Really?
"I had no idea that the major ratings agencies like Moody's and S&P were in on the con. I thought they made their money by preserving their reputations for honest assessments above all else."
Did you know who paid the ratings agencies for their assessments?
What do they put in the kool-aid that they give you guys at the cocktail parties in the Village?
I Am Puzzled Too
@Andrew - Finally! Someone whose assessment of "what economists got wrong" matches my own. I too was puzzled by Krugman's article, for much the same reason.
I have long thought that economists' professional lapse was our failure to realize that there was no "smart agent" (who was well-funded enough, anyway) to countervail the biased incentives in the system. The inability of reputation (in the case of the credit rating agencies) and of commitment to restrict federal guarantees (in the case of the shadow banking system) to equilibrate the system are examples of unwelcome surprises to the profession.
If the subject is "the professional failures of economists," Krugman's focus on the appropriate macroeconomic policy response seems almost secondary next to the antecedent problem of economists' not understanding the scope of risk being created by the financial system.
That's a long-winded way of restating "The failure was empirical"....which you said already. I agree.
Ex post criticisms of your assessment - "pasty, weasly reasoning," "fantastically naive," "ingenuous" - are easily made, but only after the incentive issue has been stated in practically "problem set" form, by which point the conclusion is obvious. Such criticisms can be easily set aside.
I am more interested in the many observers - economists and others - who flagged the incentive problems years ago: Did they gain (monetarily or professionally) from their prescience? And if not, why not? (That last question is left as an exercise to the dissertation-writer.)
I read the whole thing
And I thought it was like watching a WWE match...entertaining as soap opera, but not very "real". The us-against-them meme was particularly weird, as I have gathered that the world figured out 25 years ago that the pure CAPM was bunk and that investors were not rational. And, of course, we know that no one smart could come from Minnesota.
As to Bagehot's question, "did any of the worriers get rich?", I remember a session from Prof. Dornbusch's class back in '78, when gold was skyrocketing. After presenting information about futures pricing, he asked the class where gold prices would be in 6 months. All 20 or so of us thought the prices would be higher, in some cases much higher, than the futures price. He invited us to come with him to a futures broker to buy gold on margin with our next term's tuition payment, playing out the math of how much we'd make if the class average were achieved, no less the high estimates.
Well, no one took him up on it...because worriers are conservative. And, gold went higher than anyone in the class guessed...a $5000 investment would have returned about $1.2 million in six months. Just because you can see the future doesn't mean you have the means or guts to take advantage of it.
Regarding your first point, I
Regarding your first point, I think there are two separate issues here. If economists really did not know who paid for ratings, then they were inexcusably ignorant. There was nothing secret or sub rosa about the rating agencies' sources of income. If, however, economists believed that regardless of who paid for the ratings, the agencies could only stay in business by providing honest ratings, that error raises important questions about reputational effects which goes well beyond this particular crisis. In my opinion, just saying they "were in on the con" evades rather than confronts the problem.
Was Chicago so irrelevant?
After my obligatory IANAE statement, let me note that Krugman seems to have been right about one thing: many 'public economists' were increasingly disquieted in 2006 and 2007, but most of them were wrong about where the problem was -- they expected a dollar collapse, not a bank panic.
Moreover, I'm glad that Tom C thinks that "the world figured out 25 years ago that the pure CAPM was bunk and that investors were not rational." I keep hearing examples (thanks to their professional rivals) of people like Fama continuing to insist that stimulus can't possibly work, that markets are rational, and that government intervention is bound to make the situation worse. That common-sense empiricism shows them to be full of s**t is not comforting.
On this -- given my biased view -- it does seem that at least the prominent personages of the Chicago/real business cycle school still are insisting they are right. And I tend to think that Krugman is also right that they do so not because of empirical evidence one way or the other, but because academic trench warfare requires them to defend their positions even when the situation is overwhelmingly against them. Their defense may not help the economy, but it will help their students get jobs and their books to continue being read by other economists, and those are the relevant priorities for the personages that represent academic schools.
Bagehot, Re: am more
Bagehot,
Re: am more interested in the many observers - economists and others - who flagged the incentive problems years ago: Did they gain (monetarily or professionally) from their prescience?
Yes, some did, big time, via credit default swaps. For example, Kyle Bass. See starting at 63:42 of this video http://www.cnbc.com/id/15840232?video=1145392808&play=1
"if you had even convinced
"if you had even convinced them that the ratings were being paid for by the sellers of the securities, not the buyers, then basic economic theory would have suggested that the problems of biased ratings would have been severe."
Why did economists advising the buyers fail to appreciate this?
The ratings fox watching the hen house
Andrew,
I haven't been following whatever reform efforts for ratings may be underway or under discussion. What is being considered or proposed (or already implemented), and what do you suggest as regulatory reform, if any, to reduce or eliminate this dynamic of the ratings agencies acting like foxes watching the hen house (giving artificially high ratings on securities of their customers to boost their own revenue).
thanks
Ever Watch the Case-Schiller Index?
The highest high in the Case-Schiller index for the past several decades was about 150. In the past, this level marked a real estate bubble. During this last bubble, the index went to about 225, or 50% higher than the highest high.
It was well known that an enormous amount of debt based upon these inflated home values. It was also know that this debt was being collateralized, re-packaged, and re-sold for more "value".
If you can't recognize that this is the precursor to a major fall, maybe you shouldn't be an economist. Or maybe we just have to accept the old axiom, "economists have 20-20 hindsight."
the rating agencies
Professor Samwick, you might find it worthwhile to look at the complexities in assessing the rating agencies discussed in this paper:
http://www.nber.org/papers/w15045
More generally as well, being compensated by suppliers for assessing something they supply gives you in some circumstances short-term incentive to pander to them even while thereby soon destroying your reputation, but the long-term incentive in many reasonably-assumed business circumstances is of course to build and maintain your reputation for best-effort independent analysis.
Economist rely on models, not real life
Economist failed to predict that the economy was moving in the wrong direction because they based their assumptions on theories, not actual human behavior. When people get overly greedy, manipulate the system, or get scared and run for the exits -- all economic models become useless.