Responding to Professor Krugman’s Opus

Recently, New York Times columnist and Nobel Prize winner Paul Krugman wrote an essay entitled, “How Did Economists Get it So Wrong?” in which he argues that the recession points to a muddy future for economic theory and a greater legitimacy for behavioral economics.

I agree with Krugman that academic macroeconomics went haywire some years ago. Many economists got out of academic macroeconomics because there seemed to be no way to fight the emerging and mistaken consensus. One place that fought the good fight for sensible macroeconomics was Brookings, where the Brookings Papers on Economic Activity remained true to sensible macroeconomics at the price of losing credibility with the academic profession.

What is less clear is whether actual macroeconomic policymaking in Washington was greatly influenced by the papers in the economics journals. My experience in the Clinton Administration in the 1990s, including the interactions with the Federal Reserve, suggested that actual stabilization policy was governed by a pragmatic view of the economy that combined the important lesson from Keynes about the potential instability of the economy together with what we learned subsequently in the postwar period, including the substantial power of monetary policy—something that Keynes downplayed.

The pragmatic consensus among policymakers failed miserably in this crisis because the postwar period lulled us into a false sense of security. We believed that adjusting short term interest rates and using occasional fiscal policy were all that was needed to avoid a major recession. After all, there was almost uninterrupted economic growth from the mid 1980s until 2007, despite some pretty big shocks to the economy, including the technology bust and the 9/11 attacks. The policy failure was a very bad one, but it is hard to blame it on an excessive reliance on economic theory.

Give some credit to the Chicago School. Following the Great Depression and the war, there was a massive expansion of government regulation in areas such as transportation and telecommunications. George Stigler and Milton Friedman pointed to the problems created by such regulation and the tendency of regulators to be influenced or captured by the companies they are supposed to regulate. The deregulation movement started under Carter and was supported by Ted Kennedy as well as Republicans, and overall it has had beneficial effects. Why should the government decide which airline flies between two cities and what fare is charged? In studies of productivity in many industries and many countries, research by the McKinsey Global Institute (that I worked on) showed that poorly executed regulation has held back economic performance in many countries. Those policymakers that embraced deregulation and competition have seen the payoffs, including the UK, Australia, China and the United States.

As I said earlier, the successes of macroeconomic stabilization policy resulted in a complacency that contributed to the current crisis. The success of industry-level deregulation policies also caused problems. It encouraged the deregulation of the electricity sector without adequate safeguards and with disastrous consequences in California and elsewhere. It encouraged the deregulation of the financial sector and, more importantly, to a laxity by regulators who failed to appreciate excessive risk taking and the inherent instability of this sector. The consequences are the ones that Krugman describes so forcefully.

Krugman blames bad economic theory for the crisis, while I question whether economic theory really was as influential as he assumes. But at the least, economic theory did provide the intellectual rationale for policy and regulatory failures that helped get us into this mess.