Friday, September 04, 2009

What is Paul Krugman really getting at and what do economists really need to do?

I read the entirety of Paul Krugman's article in The New York Times entitled "How Did Economists Get It So Wrong?" and initially found it quite captivating and enthralling, but ultimately I found my self very disappointed. Sure, in some sense he did ultimately answer the title question by detailing for us how all of these various economic models and "schools" are simply flawed. Fine, but we already knew that from past experience, right? And telling us that economists have been "Mistaking Beauty for Truth" is not terribly helpful. He tell us about why be believes that behavioral finance and behavioral economics may be able to help us out, but I did not find his case overwhelming convincing. He does invite us to re-embrace Keynes, which is modestly helpful, but still far less than completely satisfying. In short, he simply does not deliver the goods. Instead, he gives us a partial answer and a partial prescription that both leave us thinking that something is missing.

The best part that I can find is where he says:

Economics, as a field, got in trouble because economists were seduced by the vision of a perfect, frictionless market system. If the profession is to redeem itself, it will have to reconcile itself to a less alluring vision -- that of a market economy that has many virtues but that is also shot through with flaws and frictions. The good news is that we don't have to start from scratch. Even during the heyday of perfect-market economics, there was a lot of work done on the ways in which the real economy deviated from the theoretical ideal. What's probably going to happen now -- in fact, it's already happening -- is that flaws-and-frictions economics will move from the periphery of economic analysis to its center.

That is good stuff and all well and good, but trying to model "flaws and frictions" with some significant degree of accuracy for a massive economy such as ours is probably yet another fool's errand.

I am still struggling to collect my own thoughts on what went wrong, but my hunch is that there is still plenty of essential data that is not yet public. Maybe five years from now we will have enough of the key and essential facts available to actually pinpoint the small number of avoidable mistakes that brought the crisis upon us and that realistically could have been avoided.

I see that there are two critical but rather distinct questions before us:

  1. How do we assure both a healthy and vibrant economy and that we do not have a replay of this crisis over the next 75 years?
  2. How do we anticipate and avoid other forms of financial crisis that are wholly different from this and all previous financial crises that might occur 75 to 100 years from now?

If you go back to 1930 and ask people whether the U.S. will be able to "fix the system" so as not to have another depression for at least 75 years, who would have believed it would be possible, but yet we actually did it.

On the other hand, what could "the authorities" really have done back in 1930 to have avoided this latest crisis? I think that is the question we want answered and in a way that will enable us to avoid a major crisis 75 years from now. I did not find Paul Krugman's piece at all enlightening in that sense.

I do have some of my own ideas, but I am still struggling with them.

I do think we need to rethink our definitions for money, capital, credit, banks, non-bank financial institutions, etc. in a way that accounts for the roles of massive hedge funds, foreign capital, and offshore entities, not to mention non-banking financial activity within banks (e.g., Citigroup and its gigantic securitization SIV.)

We need to refine our conception of the Federal Reserve to give it even more power, but in a more focused manner that keeps the Fed focused on its primary mission. The Fed could have interceded and moderated the crisis more effectively, but as the institution is currently formulated they were unable to "see" the true nature of the problem in real-time.

The key missing ingredient is an overall regulatory framework that is agile and able to both allow innovation and to simultaneously recognize when regulation needs to be applied to innovation.

The alternative is what we just experienced. It is called the Greenspan Doctrine. Rather than try to avoid all crises, the regulatory framework is designed to flexibly and rapidly clean up the mess after the fact. To be clear, that is where we are today. That is the default. We are in fact in the process of proving that this doctrine does still work. Yes, it is working, but the costs and level of pain are quite extreme and widely considered unacceptable.

The risk with replacing the Greenspan Doctrine is that we either end up stifling the economy and innovation or actually inducing mini-crises as we distort the economy and financial system at times when we perceive that a crisis might be developing when in fact there is no true crisis developing. In other words, when the cure is worse than the disease.

In any case, Paul Krugman, et al, have a lot more work to do to answer his headline question with a greater degree of utility.

-- Jack Krupansky


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