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Where Does Macroeconomics Go From Here?

Which Economists Got it So Wrong?

I remember 2004-2006 being years in which sensible economists made good arguments--or arguments that seemed to me to be good at the time--that we should not worry about a recession brought on by the collapse of a housing bubble. As I recall, there were six of them:

  • Any subprime housing bubble is much smaller than the dot-com bubble was.
  • Americans will keep paying their mortgages even though their houses are a little bit underwater.
  • Banks will be forgiving in a mortgage crisis because it is very bad to have an interest in a house that will stay vacant for any considerable period of time.
  • Wall Street firms originating mortgage-backed securities this decade are like the venture capital firms of last decade--they follow the originate-and-distribute model, and the unwinding of the dot-com bubble did not create systemic risk
  • In fact, we have had six potential financial crises since Alan Greenspan became Chair of the Fed--1987, 1990, 1994, 1997, 1998, 2000--and all six were nipped in the bud because the Federal Reserve has the tools and the will to stabilize the system because it can create unlimited amounts of what are the safe assets in the global economy.
  • The potential crisis to worry about is the dollar crisis--because that is a crisis that the Federal Reserve cannot fix, for once the dollar becomes risky its power drains away. We should be worring about that.

Paul Krugman has a very different view:

How Did Economists Get it So Wrong?: In recent, rueful economics discussions, an all-purpose punch line has become “nobody could have predicted...” It’s what you say with regard to disasters that could have been predicted, should have been predicted and actually were predicted by a few economists who were scoffed at for their pains. Take, for example, the precipitous rise and fall of housing prices. Some economists, notably Robert Shiller, did identify the bubble and warn of painful consequences if it were to burst. Yet key policy makers failed to see the obvious. In 2004, Alan Greenspan dismissed talk of a housing bubble: “a national severe price distortion,” he declared, was “most unlikely.” Home-price increases, Ben Bernanke said in 2005, “largely reflect strong economic fundamentals.”

How did they miss the bubble? To be fair, interest rates were unusually low, possibly explaining part of the price rise. It may be that Greenspan and Bernanke also wanted to celebrate the Fed’s success in pulling the economy out of the 2001 recession; conceding that much of that success rested on the creation of a monstrous bubble would have placed a damper on the festivities.

But there was something else going on: a general belief that bubbles just don’t happen. What’s striking, when you reread Greenspan’s assurances, is that they... were based on the a priori assertion that there simply can’t be a bubble in housing. And the finance theorists were even more adamant on this point. In a 2007 interview, Eugene Fama, the father of the efficient-market hypothesis, declared that “the word ‘bubble’ drives me nuts,” and went on to explain why we can trust the housing market: “Housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed.” Indeed, home buyers generally do carefully compare... the price of their potential purchase with the prices of other houses. But this says nothing about whether the overall price of houses is justified. It’s [Larry Summers's] ketchup economics [point], again: 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....

Now that the undiagnosed bubble has burst, the true riskiness of supposedly safe assets has been revealed and the financial system has demonstrated its fragility. U.S. households have seen $13 trillion in wealth evaporate. More than six million jobs have been lost, and the unemployment rate appears headed for its highest level since 1940. So what guidance does modern economics have to offer in our current predicament? And should we trust it?...

Let me say that I agree with everything Paul Krugman writes about today's Chicago School--a group who would dismiss Milton Friedman as a dangerously interventionist leftist were he with us today, and a group who seem to me to know little about the economy and to have thought less about fundamental issues in monetary economics that I used to teach my graduate students were settled once and for all in the 1920s and 1930s. Their influence on the future of economics ought to be reduced to a smidgeon of its current value--they made big intellectual bets on what the world is like, and they lost, and they should pay.

The big lesson, I think, is that Wall Street is much less sophisticated than we imagined it was: Goldman Sachs simply did not do any of the due diligence it needed to do to understand the AIG-specific risks it was assuming, Citigroup was unable to manage its own derivatives book to understand what "liquidity put" risks it was assuming, and as for Bear Stearns, Lehman Brothers, Merrill Lynch--hoo boy...