Thursday, September 3, 2009

Getting it wrong

Economist Paul Krugman has a New York Times Magazine article entitled How Did Economists Get It So Wrong? which has a nice description of the mainstream of economic thinking since the Great Depression.

He winds up arguing that the only way forward is a return to government spending as a response to business cycle downturns. He treats this as a far more settled conclusion than I believe it to be. Regardless, Krugman's walk through recent economic thinking has value even if you don't think we ought to double down on Keynesian spending the way Krugman does so you should go read the whole thing.

Of particular importance to understanding this crisis is understanding the role of finance:
By 1970 or so, however, the study of financial markets seemed to have been taken over by Voltaire’s Dr. Pangloss, who insisted that we live in the best of all possible worlds. Discussion of investor irrationality, of bubbles, of destructive speculation had virtually disappeared from academic discourse. The field was dominated by the “efficient-market hypothesis,” promulgated by Eugene Fama of the University of Chicago, which claims that financial markets price assets precisely at their intrinsic worth given all publicly available information. (The price of a company’s stock, for example, always accurately reflects the company’s value given the information available on the company’s earnings, its business prospects and so on.)

The notion that market actors are always rational and that market prices are always correct seems foolish regardless of where you fall on the political spectrum. To accept such a notion, one would have to accept a fundamental change in human nature.

If you are one who believes we live in a fallen world, there is absolutely no way, short of split personalities, that you can also believe in the perpetual accuracy of market prices. The flip side to this of course, is the fact that no amount of government intervention is going to permanently alleviate all human suffering whether caused by economic striving or not.

This is not to say we should do nothing. Nihilism is not an option. A measured approach to implementing prudential but substantial changes is my preferred course. It's possible, perhaps even likely, that the Obama approach will be one of highly publicized cosmetic changes and then business as usual on Wall St.

Economists that overturned the thinking of Keynes in the academy weren't right, and it's not at all clear that Keynes' approach still holds true. Given this state of affairs, without some new thinking when it comes to finance, we could find ourselves continuing to 'get it wrong' for a very long time.

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