How economists got it so wrong?

What is at stake: Back in November 2008, HM Queen Elizabeth II wondered why no one saw the crisis coming. Around the same time, Alan Greenspan was admitting that he was in a state of shocked disbelief because the whole intellectual edifice had collapsed. Since then, the controversy around the role of economists in the crisis and the direction the economics profession should take from there has not fade. The publication in Sunday's New York Times Magazine of a long dissection of the state of economics by Paul Krugman has triggered a new wave of reactions.

Paul Krugman says that the economics profession went astray because economists mistook beauty for truth. 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. Krugman argues that the story of economics over the past half century is, to a large degree, the story of a retreat from Keynesianism to a romanticised and sanitised vision of the economy that led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.

Barry Eichengreen says that the problem lay not so much with the poverty of the underlying theory as with selective reading of it. The late twentieth century was the heyday of deductive economics. Talented and facile theorists set the intellectual agenda. Their very facility enabled them to build models with virtually any implication, which meant that policy makers and investors could pick and choose at their convenience. Theory turned out to be too malleable, in other words, to provide reliable guidance for policy.

David Altig of the Atlanta Fed's macroblog says that he is not convinced that we require a major paradigm shift. Despite suggestions to the contrary, I've yet to see the evidence that progress requires moving beyond the intellectual boundaries in which most economists already live. The problem was that our mechanism for capturing monetary nonneutrality – essentially wage and price stickiness – was far too simplistic to capture the shocks that we were about to face (and that we arguably faced to lesser degrees during past financial market events).

Philip Lane says that there is no doubt that the crisis has underlined a misallocation of research resources. The social costs of rare-but-large crashes are so large that it is clear in retrospect that too few researchers were focused on the economics of large crises. While there is much to regret concerning the course of pre-crisis research, it is also true that many of the technical innovations over the last 20 years are now being applied in exciting ways to design crisis-resolution policies. 

Noam Scheiber says that the one thing that makes him optimistic is that knowledge in economics is countercyclical.

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