Near Perfection from Paul Krugman (and the Disorder)

Paul Krugman has an article in New York Times Magazine, How Did Economists Get It So Wrong?, that has to be classified as brilliant in detailing the failure of mainstream economics in foreseeing and understanding the economic downturn we are now in. Writes Krugman:

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....There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year....As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.

Bravo! I couldn't have nailed mainstream economists any better myself.

He does split mainstream economists into two camps, the saltwater economists (on the east coast and west coast) and the freshwater economists (surrounding the University of Chicago and Great Lakes). However, salt water or freshwater, he makes clear they are all wet.

He manages to take out Alan Greenspan:

By October of last year, however, Greenspan was admitting that he was in a state of “shocked disbelief,” because “the whole intellectual edifice” had “collapsed.”

He takes out current top adviser to President Obama, Larry Summers:

One brave attendee, Raghuram Rajan (of the University of Chicago, surprisingly), presented a paper warning that the financial system was taking on potentially dangerous levels of risk. He was mocked by almost all present — including, by the way, Larry Summers, who dismissed his warnings as “misguided.”

He takes out fellow Nobel Prize winner Edward Prescott:

Instead, the new leaders of the [freshwater] movement, especially Edward Prescott, who was then at the University of Minnesota (you can see where the freshwater moniker comes from), argued that price fluctuations and changes in demand actually had nothing to do with the business cycle. Rather, the business cycle reflects fluctuations in the rate of technological progress, which are amplified by the rational response of workers, who voluntarily work more when the environment is favorable and less when it’s unfavorable. Unemployment is a deliberate decision by workers to take time off.

Put baldly like that, this theory sounds foolish — was the Great Depression really the Great Vacation? And to be honest, I think it really is silly. But the basic premise of Prescott’s “real business cycle” theory was embedded in ingeniously constructed mathematical models, which were mapped onto real data using sophisticated statistical techniques, and the theory came to dominate the teaching of macroeconomics in many university departments.

Then he takes out Mankiw, Romer and Blanchard:

Meanwhile, saltwater economists balked. Where the freshwater economists were purists, saltwater economists were pragmatists. While economists like N. Gregory Mankiw at Harvard, Olivier Blanchard at M.I.T. and David Romer at the University of California, Berkeley, acknowledged that it was hard to reconcile a Keynesian demand-side view of recessions with neoclassical theory, they found the evidence that recessions are, in fact, demand-driven too compelling to reject. So they were willing to deviate from the assumption of perfect markets or perfect rationality, or both, adding enough imperfections to accommodate a more or less Keynesian view of recessions. And in the saltwater view, active policy to fight recessions remained desirable.

But the self-described New Keynesian economists weren’t immune to the charms of rational individuals and perfect markets. They tried to keep their deviations from neoclassical orthodoxy as limited as possible. This meant that there was no room in the prevailing models for such things as bubbles and banking-system collapse. The fact that such things continued to happen in the real world — there was a terrible financial and macroeconomic crisis in much of Asia in 1997-8 and a depression-level slump in Argentina in 2002 — wasn’t reflected in the mainstream of New Keynesian thinking.

Then, he goes after Fed chairman Ben Bernanke:

Home-price increases, Ben Bernanke said in 2005, “largely reflect strong economic fundamentals.”

Then he bangs the entire gang:

But there was something else going on: a general belief that bubbles just don’t happen.

Since Krugman is a wetman, also (saltwater version), his interspersed comments about what went wrong are off mark, as is his belief (hope?)that behavioral economics will provide a life preserver. A discussion by me of behavioral economics will have to wait for another day.

What must be emphasised at this point is that Krugman writes only of wetmen. He completely ignores the one group that have consistently warned that the business cycle has not been wiped from the world of central bank manipulated money supply growth, namely, the Austrian School of Economists.

In his description of the debate over the Great Depression he describes the debate as one between the John Maynard Keynes school and the Milton Friedman school. He does not mention even once his fellow Nobel laureate, Austrian school economist Fiedrich Hayek, who won his Nobel Prize for, among other things, and I quote the Nobel Committee:

...pioneering work in the theory of money and economic fluctuations..

As for the current downturn, Austrian economists Richard Ebeling, Peter Schiff, Stefan Karlsson, Mark Thornton and me, all, warned of the bubble ahead. Not a one of us got caught in what Krugman calls "predictive failure."

I have no answer to why Krugman refuses to discuss Austrian economists. It is truly bizarre. In a recent C-span appearance, he was a combination of rattled and dismissive of the Austrian school, in a manner reminscent of those who dismissed the warnings of Peter Schiff on live television.

For the record, here's how the Austrians view the business cycle, and why they expect, as long as there is central bank manipulation of the money supply, that business cycles have not been wiped from the planet earth:

A central bank prints money, which then enters the economy through the banking sector, and largely that money goes to the capital goods sector, e.g. the stock market, the housing market. This distorts the consumption-savings ratio in favor of savings (meaning more money is spent on capital goods than consumer goods). If a central bank stops printing (or significantly slows printing) the economy re-adjusts to the old consumption-savings ratio, which means there is less money available for capital goods, such as, housing and the stock market. Thus, during a period when a central bank stops or significantly lowers its money printing, housing prices and stock pricess experience declines (along with accompanying increases in unemployment in generally those sectors).

What is so hard to get about this theory? If there is a flaw in a theory that seems to match what has been going on, what is it? Why won't Krugman even mention the theory in his discussion, even when a fellow Nobel Prize laureate won his Nobel Prize, in part, for his work on this theory?
Was Krugman doing a bit of self analysis when he wrote,"As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth"? Hayek, in a brilliant book, The Counter-Revolution of Science, discussed this very problem of impressive looking mathematics that has nothing to do with truth. This really is a disorder, the Wetman's Disorder, if you will. It's a serious block to clear thinking. Judging by Krugman's brilliant analysis of it, coupled with his inability to break free of it, we really shouldn't be expecting much in the way of acceptance of the business cycle from any of these guys.