Saltwater Economists

http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?emc=eta1

There is probably a reason why Fox News data shows that Paul Krugman's blog is the most widely read in the world (and yes, Thomas L. Friedman - he of "The World Is Flat" - is number 2). Aside from winning the most recent Economics Nobel, Krugman speaks and writes in terms we can all understand. He will also take on (in any medium - TV, articles, public debates at universities, etc.) any of the pompous, self-important and narrow minded members of his profession that prefer to live in "theory" as opposed to the real world.

Krugman has written an article this week that is scheduled to be published in the Sunday NY Times Magazine this weekend on "How Did Economists Get It So Wrong?" (copy attached). In it, he basically points out that "The Great Recession" was the result not only of lax regulation in Washington and reckless risk-taking on Wall Street but also of "faulty theorizing" in academia. The singular achievement of his article is that he has summarized what happened much more cogently than various books that have already been written about it. It is so good that it will probably be remembered as the greatest article he ever wrote.

Aside from the bottom line of what needs to be done, which we'll get to in a moment, Krugman gives us an insight into the "Saltwater Economists" (mainly in coastal U.S. universities), who have a more or less Keynesian vision of what recessions are all about; and "Freshwater Economists" (mainly at inland schools) who consider that vision nonsense. So, freshwater economists are "purists" who believe that all worthwhile economic analysis starts from the premise that people are "rational" and markets work. Saltwater economists were and are pragmatists. They were willing to deviate from the assumption of perfect markets, adding enough imperfections to accomodate a more or less Keynesian view of recessions: active policy to fight recessions remains desirable. While Krugman doesn't put it this way, it would appear that the saltwater economists had it right because there is no longer any debate about how fiscal stimulus has helped the current economic situation.

What fascinates Krugman is the stance that Alan Greenspan took, based on a general belief that "bubbles just don't happen" (or my favorite: "financial markets are self-regulating"), which was based on no evidence: "...it was an a priori assertion that there simply can't be a bubble in housing." In short, the belief in efficient financial markets "...blinded many if not most economists to the emergence of the biggest financial bubble in history."

To Krugman, economics, as a field, got into trouble because economists were "seduced" by the vision of a perfect, frictionless market system. So, now, "flaws-and-frictions" economics will move from the periphery of economic analysis to the center. And, the best example of this form of economic thought is: the school of thought known as "Behavioral Finance" where investors bear little resemblance to the cool calculators of efficient-market theory - here investors are too subject to herd behavior, to bouts of irrational exuberance and unwarranted panic. Behavioral finance, drawing on the broader movement known as behavioral economics, tries to relate the apparent irrationality of investors to known biases in human cognition, like the tendency to care more about small losses than small gains or the tendency to extrapolate too readliy from small samples.

Given all of this, we have Krugman quoting one of his old favorite lines: "the market can stay irrational longer than you can stay solvent." So, as Krugman goes on, "...economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly." Unlike his profession, Krugman's article approaches perfection.