Economics Theory: What Went Wrong

Here are some bits from a post by Paul Krugman on his NY Times blog that look at how and why the economics theories of the past 40 years were useless in the face of the Great Recession.

Here is the key bit:

...if all we had known when this crisis struck was 1950-vintage macroeconomics, we would probably have done a better job of responding.

And this:

Mark Thoma jokes that “I’ve learned that new economic thinking means reading old books.” And Brad DeLong says that it’s no joke: the macroeconomics of 1936 — or even of 1873 — is a much better guide to current events and their policy implications than all the macro theory of the past few decades.

All this is very much in line with what I’ve been saying about a Dark Age of macroeconomics. But what happened, really?

And here is the explanation:

What economists have known since Bagehot (with regard to financial markets) and since Keynes (with regard to goods and labor markets) is that under some circumstances seemingly reasonable individual behavior adds up to very unreasonable macro outcomes. Bagehot wrote of panics in which the collective desire to shed risky assets and debt produced a downward spiral; Keynes of situations in which the collective desire to save but not invest led to mass unemployment. And in both cases these arguments suggested a case for government intervention to undo or limit the bad macro consequences of reasonable individual behavior.

But notice that I’ve framed this in terms of “reasonable” behavior; it’s a lot harder to tell these stories in terms of perfectly rational, maximizing behavior.

One response — a pretty good response — is, “So?” After all, maximization isn’t a fact about human behavior, it’s a gadget — an assumption we use to cut through the complexities of psychology and all that, one that can be very useful if it clarifies your thought, but by no means an axiom or a law of nature.

But maximizing models have a special appeal for modern academic economists: they require solving equations! They’re rigorous! They make it easy to show that you’re doing “real research”. And so maximization tends to acquire a bigger importance in economic thought than it deserves.

To be fair, applying maximizing thinking has achieved some major successes even in macroeconomics. The permanent income/life cycle style of consumption theory does a much better job of accounting for the stylized facts about spending than the old, mechanical consumption function. The natural rate hypothesis, with its crucial implication that high inflation would get built into expectations and not reduce unemployment, was the result of (loose) maximizing reasoning.

But from the 1970s onwards, what happened was that the drive to base everything on maximizing behavior narrowed the profession’s thinking — and, crucially, led first to a de-emphasis, then to a total forgetting, of the great insights about interaction. We created an economics profession which believed that Keynesian economics, and for that matter Bagehotian finance, had been “proved wrong”; whereas all that had really happened was that those things proved hard to model in terms of perfectly rational maximizing agents. Again, so?

And there’s a sense in which even New Keynesian economics was wasted effort, at least from a social point of view, because it was mainly a way of showing New Classical types that we can too ground the concepts we already knew in maximizing models. Actually, I don’t think that’s entirely fair: I find that New Keynesian models, especially on the liquidity trap issue, do deepen my understanding. Still, you can understand why Larry Summers says that none of that stuff proved useful in actual policymaking.

The art of science is to simplify to make explanation possible but not to simplify too much which distorts the "science" into a parody of itself because it explains nothing but an idealization that no longer applies to the real world. Sadly, the economics of the late 20th century fell into this trap. They loved their homo economicus so much that their theories no longer applied to the real world.