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An Open Letter to Paul Krugman

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Dear Paul:



I was reading your article How Did Economists Get It So Wrong.
Who are these economists who got it so wrong? Speak for yourself kemo
sabe. And since you got it wrong - why should we believe your
discredited theories?

    It is a sad fact that whenever something bad happens people
will claim that it means that they were right all along, and other
people will listen to them. A professional prosecutor frustrated by the
fact that you can't beat confessions out of suspects? Wait until
September 11 and try again and this time call it the "Patriot Act." A
progressive who would like to see higher taxes and more government
programs? Wait until there is an economic crisis and call it a "fiscal
stimulus bill." Here we are, the recession is over and we've spent 10%
of the money...Not the 200% you thought we needed to end the recession.

    It is a daunting task to bring you up to date on the developments in economics in the last quarter century. I know that John Cochrane
has tried to educate you about what we've learned about fiscal
stimulae in that period. But perhaps a I can highlight a few other
developments? You seem under the impression that economists had
resolved their internal disputes before the financial crisis. So that
means you haven't followed the debate
about the causes of depressions between Peter Temin on one side and
Timothy Kehoe and Ed Prescott on the other? You say that we think that
the "central problem of depression-prevention has been solved." Has it
not? Are you forecasting that this recession will turn in to a
depression? But of course "More important was the profession's
blindness to the very possibility of catastrophic failures in a market
economy." That would be the profession that hasn't been reading what
the profession has written? Perhaps you should go look at that
controversial book Kehoe and Prescott [2007], Great Depressions of the 20th Century. Or you might read Sargent, Williams and Zhao [September 2008], "Conquest of Latin American Inflation". Wouldn't it be nice if people had some idea of what was being written before criticizing it? 

    Let us talk more seriously about the supposed failure of the
economics profession. You say "Few economists saw our current crisis
coming, but this predictive failure was the least of the field’s
problems." The predictive failure is not a problem of the field - it is
a problem for those who are under the impression that we should be able
to predict crises. Do you number yourself in this bunch? Do physicists
get it wrong because their theory says that they cannot predict where a
photon shot through a sufficiently narrow slit will land? Economic
models are like models of photons going through slits. Just as those
models predict only the statistical distribution of photons, so our
models only predict the likelihood of downturns - they do not predict
when any particular downturn will occur. Saying "most economists failed
to predict the downturn" is exactly like saying most physicists failed
to predict the impact of the twelfth photon passing through the slit.

    More to the point: our models don't just fail to predict the
timing of financial crises - they say that we cannot. Do you believe
that it could be widely believed that the stock market will drop by 10%
next week? If I believed that I'd sell like mad, and I expect that you
would as well. Of course as we all sold and the price dropped, everyone
else would ask around and when they started to believe the stock market
will drop by 10% next week - why it would drop by 10% right now. This
common sense is the heart of rational expectations models. So the
correct conclusion is that our - and your - inability to predict the
crisis confirms our theories. I feel a little like a physicist at the
cocktail party being assured that everything is relative. That isn't
what the theory of relativity says: it says that velocity is relative.
Acceleration is most definitely not. So were you to come forward with
the puzzling discovery that acceleration is not relative...

    Of course some people did predict the crisis. Some might even
have been smart enough to know that if they consistently predict the
opposite of a consensus point forecast, eventually they will be right
when everyone else is wrong. If I say every year: there will be war;
there will be an asset market crash; there will be a recession; there
will be famine; we will run out of oil - eventually I'll be right.
These kind of predictions are only meaningful if more people than can
be attributed to random good luck got it right at the right time or if
whatever method they used to reach that conclusion is replicable. Or
does the ability to replicate results fall under the category of "not
very interesting because that would be an elegant theory?"

    But let's turn to what you say are our deeper failures. We
"turned a blind eye to the limitations of human rationality that often
lead to bubbles and busts." It makes me feel physically ill that a
distinguished economist could be so ignorant of his own profession. As
a random example, how about my student Felipe Zurita's thesis on speculation written in 1998?
There are endless papers written about bubbles and busts - some
assuming rationality, some not. Some are experimental, some are
theoretical, some are empirical. There are economists who have devoted
their entire careers to studying bubbles. There is a fellow named Stephen Morris. He isn't what you would call a fringe member of the economics profession - he's the editor of Econometrica
which, as you know, is one of the leading journals in economics. He has
written extensively about bubbles. I take it you aren't familiar with
his work. Perhaps you should walk down the hall and stick your head in
his office and ask him about it? Each crisis - in Mexico, in South-east
Asia, in Argentina - had generated hundreds of papers examining how and
why the crisis took place.

    Efficient markets? Where have you been for the last quarter
century? The modern theory of how financial markets incorporate
information is that they do so imperfectly. The technical device is
that of noise traders originating in a 1985 paper of Admati. But I
think you knew of the idea earlier. In 1980 when you were a visitor at
MIT, you participated in a graduate student seminar...in which I
presented a paper starring noise traders...

    Do we really need some sort of behavioral model to understand
why asset prices fall abruptly? If opinions about asset values change,
prices must fall abruptly - it isn't irrational to run for the exits
when the theater is on fire. In addition to a beautiful 1983 paper of
Steve Salant there is a large literature on bank runs and contagion,
not to speak of credit and collateral cycles. If there was some sort of
irrationality involved in a panic, prices ought to bounce right back
the next day when everyone wakes up and sheepishly realizes that they
were wrong. In fact asset prices seem to be tracking news of
fundamentals pretty well - gradually recovering as we get better news
about fundamentals.

    Has behavioral economics offered anything that would help to solve
the market failures that characterized this crisis? Was it herd
behavior or animal spirits? Or was it risks that were not being
priced?  Serious economists like Lasse Pedersen
try to analyze how liquidity risks created systemic problems and think
about how to incorporate them into our understanding of how to
ameliorate future crises.  They don't shake their heads and revert to
discredited static theories of the 1930's.

    Crises have been ubiquitous throughout history. While we can't
forecast them we do know how to learn from them. And we certainly have
a good idea what not to do in response: do what Chile did successfully
- fail banks and recycle them, not do what Japan did unsuccessfully -
keep the zombie banks limping feebly around. Like me you saw the bank
bailout plan for what it was - not a necessary step to save the credit
sector from collapse but a give-away of taxpayer money to investment
bankers. But the stimulus plan? How can you be arguing for more? Since
we are recovering before most of the stimulus money has entered the
economy - isn't that evidence it isn't needed? How can you write as if
you are proven right in supporting it?

Regards,

David

[Thanks to Tom Cooley for talking this through.]