In “How Did Economists Get It So Wrong?,” a lengthy essay on the financial crisis, New York Times columnist and Nobel laureate Paul Krugman urges fellow economists to re-embrace Keynesian theory, which would help “incorporate the realities of finance into macroeconomics.” In Krugman’s view, we should accept that finance introduces unacceptable gyrations into the broader economy and learn how to smooth these fluctuations with government spending, following the principles of economist John Maynard Keynes. But Krugman’s critique overestimates the importance of academic theory at the expense of what happens in the real world.

Krugman begins by arguing that the American economy “ran off the rails” because, over the past three decades or so, respected scholars—and the bankers, regulators, and politicians who listened to them—forgot that unbridled financial markets could cause great risks to the larger economy. Instead, they came to believe that these all-knowing markets didn’t need much government interference. The almost indistinguishable division that remained, Krugman writes, “was between those who insisted that free-market economies never go astray and those who believed that economies may stray now and then but that any major deviations . . . could and would be corrected by the all-powerful Fed.” Economists didn’t worry about matters such as whether rising home prices could pose a danger to the economy if they suddenly fell, leaving behind hundreds of billions in unpaid debt. They figured that market participants knew what they were doing. The academic theory loosely underpinning this general belief was “efficient market hypothesis,” which holds that “financial markets always get asset prices right given the available information.”

Seduced by markets, Krugman continues, academics and their followers didn’t worry that inadequately regulated financial markets might create a disaster in the rest of the economy, as they had in the Depression; nor did anyone think about what the government should do to prevent or recover from such a disaster. The academics thus neglected the theories of Keynes, the British economist who did much of his work between the World Wars. Keynes warned about the imperfections of financial markets, but as Krugman notes, he’s more famous for his Depression-era idea that economies can get stuck in slumps that won’t break without direct, aggressive government spending. By the mid-2000s, though, even academics sympathetic to Keynes “didn’t think fiscal policy—changes in government spending or taxes—was needed to fight recessions,” Krugman writes. They believed that the Fed could do it with interest rates. Nor did they worry about “such things as bubbles.” Now, in the wake of the worst financial crisis since the Depression, Krugman thinks that economists should repent of their faith in markets, turn back to Keynes, and support “active government intervention—printing more money and, if necessary, spending heavily on public works—to fight unemployment during slumps.”

But before granting a benevolent government an even greater role in managing the broad economy, we should consider taking a more modest step within the financial markets that caused the problem in the first place. We should adopt a more sensible version of the efficient-markets concept that the academics pushed and that Krugman demolishes in favor of Keynes. That is, financial markets are efficient, but the information they reflect is always imperfect and incomplete, and sometimes inaccurate. If everyone believes that house prices can only go up, for example, that’s a systemic distortion, and the distortion itself is “information” that will reflect itself in markets—quite efficiently, as we saw in the housing bubble. Similarly, if news reports were falsely to report a hurricane in the Gulf, oil prices would rise—but that’s a problem with bad information, not with the markets, which simply reflect that information.

In other words, we’re stuck with imperfect markets because we’re stuck with imperfect people with imperfect views of the present and future. From today’s vantage point, housing prices in southwest Florida circa 2005 seem absurd. But what about Manhattan condos circa 2009? Nobody can figure out whether a $500,000 studio is a steal or a rip-off. Inconsistent prices and slower sales efficiently reflect this uncertainty, and no panel of wise government men could solve the problem better. If it were up to Washington, in fact, we’d still be in a national housing bubble.

One of Krugman’s examples accidentally makes this point. In eviscerating efficient-market theory, Krugman repeats a story once told by economist Larry Summers, now a top Obama adviser. “Because a two-quart bottle of ketchup costs twice as much as a one-quart bottle, finance theorists declare that the price of ketchup must be right,” Summers once remarked derisively. But the price of ketchup is right, as far as we know. Without government interference, producers figure out how much ketchup people want and how much they’ll pay, and nobody has complained. By contrast, a government-run ketchup production and pricing system would likely result in shortages or surpluses. (Or a decree to produce mustard to please campaign contributors.)

Further, markets for goods and services (like ketchup) are different from markets for financial products (like credit-default swaps). Financial markets are acutely vulnerable to the excesses of feverish optimism and panic, and they move quickly. And while all markets eventually correct their own excesses, inadequately regulated financial markets often do so only by causing unacceptable damage to the rest of the economy. The current financial crisis and deep recession illustrate that we lack prudent and well-defined financial-market regulation to address this reality—for example, imposing the clear limits on borrowing that already exist in some parts of the financial industry to all parts of the industry, including to new markets and new types of financial companies. We should try adequately and consistently regulating the financial part of the economy directly before we move toward more random and ill-defined government interference in the ketchup economy.

Though Krugman nods toward improving financial-market supervision with a discussion of behavioral finance, he doesn’t write meaningfully about how financial regulation can prevent future financial and economic crises. Nor does he clearly acknowledge that financial markets can be both “efficient” and something close to “casinos,” as Keynes called them, requiring better and more consistent rules. Instead, he focuses on Keynes’s idea that government should manage the broader economy more actively.

But if more direct, Keynes-style “changes in government spending or taxes” over the past two decades, rather than more nuanced understanding and proper regulation of financial markets, would have prevented the financial crisis, it’s not apparent from Krugman’s article. Indeed, though Keynes may have fallen from favor in academia as Krugman describes, he did not fade from government policy. Keynesian theory holds, for example, that governments shouldn’t worry about balancing budgets in bad times, because increasing government spending through deficits can counteract decreasing private-sector activity. We’ve followed that Keynesian advice consistently for decades. Government spending on unemployment benefits and food stamps goes up during recessions, a natural government boost to the economy. Last year, President Bush and a Democratic Congress approved a stimulus package that included cash rebates to encourage people to spend money—another Keynesian technique.

And it certainly didn’t take long for the supposedly long-vanished Keynesian thinking to reassert itself in President Obama’s February stimulus. Reasonable critics of the stimulus haven’t challenged its existence so much as its size and priorities. Washington has fully embraced Keynes already and even gone well beyond him, without needing much intellectual encouragement—consider the government stake in Citigroup, or the joint government and union stakes in General Motors and Chrysler.

The financial crisis itself came about partly because Washington policy has long been far closer to active government economic management than to free-market purity. For 25 years, whenever the financial industry stumbled, Washington bailed it out, using government tools far beyond interest-rate cuts to make sure that the economy didn’t suffer the consequences of the financial industry’s behavior. What mainstream politician or regulator agreed with the free-market academics whom Krugman quotes as saying that recessions were “a good thing, part of the economy’s adjustment to change”? For decades, Democrats and Republicans alike propped up the financial sector to avoid a slowdown in debt creation and the inevitable economic “adjustment” that would ensue. And the financial industry came to depend on this propping-up, increasingly employing business models based in reality on investors’ expectations of future government protection, not on academic efficient-markets theory.

Unfortunately, Washington will likely see Krugman’s article as an excuse to expand the government’s already-ample role in the rest of the economy—permanently. Krugman has given pols an intellectual justification for their vague notion that they can continue to let government-favored financial markets run wild, papering over the inevitable problems in the rest of the economy with more and better government management and spending. Both of these forces—the financial markets’ recklessness and Washington’s consistent subsidizing of it, thinking it can clean up after the fact—will work together to suffocate the nonfinancial private sector. That would be a dreary development for the economy, which should be weaning itself from its overgrown dependence on finance by allowing market forces to work.


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