Afternoon Must-Read: Justin Fox: The Federal Reserve: Regulatory Capture Observed in the Wild
Weekend Reading: Charles Evans: Patience Is a Virtue When Normalizing Monetary Policy

Weekend Reading: Paul Krugman: Review of Jeff Madrick, 'Seven Bad Ideas'

Paul Krugman: 'Seven Bad Ideas,' by Jeff Madrick: "The economics profession has not, to say the least...

...covered itself in glory these past six years. Hardly any economists predicted the 2008 crisis — and the handful who did tended to be people who also predicted crises that didn’t happen. More significant, many and arguably most economists were claiming, right up to the moment of collapse, that nothing like this could even happen.

Furthermore, once crisis struck economists seemed unable to agree on a response. They’d had 75 years since the Great Depression to figure out what to do if something similar happened again, but the profession was utterly divided when the moment of truth arrived.

In “Seven Bad Ideas: How Mainstream Economists Have Damaged America and the World,” Jeff Madrick — a contributing editor at Harper’s Magazine and a frequent writer on matters economic — argues that the professional failures since 2008 didn’t come out of the blue but were rooted in decades of intellectual malfeasance.

As a practicing and, I’d claim, mainstream economist myself, I’m tempted to quibble. How “mainstream,” really, are the bad ideas he attacks? How much of the problem is bad economic ideas per se as opposed to economists who have proved all too ready to drop their own models — in effect, reject their own ideas — when their models conflict with their political leanings? And was it the ideas of economists or the prejudices of politicians that led to so much bad policy?

I’ll return to those quibbles later, but Madrick’s basic theme is surely right. His bad ideas are definitely out there, have been expressed by plenty of economists, and have indeed done a lot of harm.

So what are the seven bad ideas? Actually, they aren’t all that distinct. In particular, bad idea No. 1 — the Invisible Hand — is pretty hard to distinguish from bad idea No. 3, Milton Friedman’s case against government intervention, and segues fairly seamlessly into bad idea No. 7, globalization as something that is always good. As an aside, this sometimes makes Madrick’s argument more disjointed than I’d like, with key propositions spread across nonconsecutive chapters. But there is an important point here, and Madrick has clarified my own thinking on the subject.

Adam Smith used the phrase “invisible hand” only once in “The Wealth of Nations,” and he probably didn’t mean to say what most people now think he said. But never mind: Today the phrase is almost always used to mean the proposition that market economies can be trusted to get everything, or almost everything, right without more than marginal government intervention.

Is this belief well grounded in theory and evidence? No. As Madrick makes clear, many economists have, consciously or unconsciously, engaged in a game of bait and switch.

On one side, we have elegant mathematical models showing that under certain conditions an unregulated free-­market economy will produce an efficient “general equilibrium,” in the sense that nobody could be made better off without making anyone worse off. Yet as Madrick says, these assumed conditions — including the assumption that people “are rational decision makers, and that they have all the price and product information they need” — are manifestly not met in practice. What, then, do the elegant models tell us about the real world?

Well, in a different chapter Madrick recalls Milton Friedman’s dictum that economic models should be judged not by the realism of their assumptions but by the accuracy of their predictions. This lets general equilibrium off the hook, sort of. But has the proposition that free markets get it right ever been vetted for predictive accuracy? Of course not. Friedman’s own polemics on behalf of free markets consist mainly of “assertions based on how free markets may work according to the Invisible Hand,” Madrick writes, with hardly any evidence presented that they actually work that way.

In other words, economists arguing for free markets and limited government try to have it both ways: They claim that their doctrine is a deep insight derived from first principles, but dismiss as irrelevant the overwhelming evidence that these assumed principles don’t hold in practice.

Matters are even worse when it comes to the performance of financial markets. Here the proposition that markets should get it right — that major speculative bubbles can’t happen (bad idea No. 5) — doesn’t just depend on conditions that clearly don’t hold in practice, but is directly contradicted by evidence on herd behavior and excess volatility. Yet “efficient markets theory” has maintained its academic dominance. Eugene Fama of the University of Chicago, the father of efficient markets, still denies that financial bubbles even exist — and last year he shared a Nobel in economic science.

Still, all of these failings of mainstream economics were obvious long before the 2008 crisis. What has really come as news is the seeming inability of economists to agree on a policy response to mass unemployment. And here is where my quibbles with Madrick get louder.

No. 2 on Madrick’s bad idea list is Say’s Law, which states that savings are automatically invested, so that there cannot be an overall shortfall in demand. A further implication of Say’s Law is that government stimulus can never do any good, because deficit spending by the public sector will always crowd out an equal amount of private spending.

But is this “mainstream economics”? Madrick cites two University of Chicago professors, Casey Mulligan and John Cochrane, who did indeed echo Say’s Law when arguing against the Obama stimulus. But these economists were outliers within the profession. Chicago’s own business school regularly polls a representative sample of influential economists for their views on policy issues; when it asked whether the Obama stimulus had reduced the unemployment rate, 92 percent of the respondents said that it had. Madrick is able to claim that Say’s Law is pervasive in mainstream economics only by lumping it together with a number of other concepts that, correct or not, are actually quite different.

Now, it’s true that the relative handful of economists claiming that stimulus can’t possibly work, or that slashing government spending is actually expansionary, have a much higher profile than their numbers or their influence within the profession warrants. Why? Partly, the answer is that the news media — especially but not only partisan media like The Wall Street Journal’s editorial page — have promoted the views of economists they like for political reasons. Partly, also, it’s because politicians listen to economists who tell them what they want to hear. I’m not saying that mainstream economists bear none of the blame; the decades-long retreat from Keynes has undoubtedly allowed old fallacies to make a comeback. But austerity mania has to a large extent spread despite mainstream economics, not because of it.

I’d make a further observation here: Academic economists have much less influence in Europe than they do in America. Yet the policy response to the crisis, while poor on this side of the Atlantic, has been much worse on the other. Politicians don’t need bad advice from economists in order to go off the rails.

Such quibbles aside, “Seven Bad Ideas” tells us an important and broadly accurate story about what went wrong. Economists presented as reality an idealized vision of free markets, dressed up in fancy math that gave it a false appearance of rigor. As a result, the world was unprepared when markets went bad. Economic ideas, declared John Maynard Keynes, are “dangerous for good or evil.” And in recent years, sad to say, evil has had the upper hand.

SEVEN BAD IDEAS: How Mainstream Economists Have Damaged America and the World. By Jeff Madrick. 254 pp. Alfred A. Knopf. $26.95.