Paul Krugman has a great article in the New York Times entitled "’How did economists get it so wrong'?’. Go read, I suggest. Some highlights are, however:
[H]ere’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.
He adds
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.
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.
I’m amused that some have criticised me for offering this analysis on this blog. They say I know nothing of economics as a result. Well, that’s an argument. But Krugman has a Nobel prize in it. And he agrees that this is exactly the core problem.
And he criticises the Efficient Market Hypothesis Tim Worstall has declared so obviously true he cannot see how anyone can doubt it:
Until the crisis, efficient-market advocates like Eugene Fama dismissed the evidence produced on behalf of behavioral finance as a collection of “curiosity items” of no real importance. That’s a much harder position to maintain now that the collapse of a vast bubble — a bubble correctly diagnosed by behavioral economists like Robert Shiller of Yale, who related it to past episodes of “irrational exuberance” — has brought the world economy to its knees.
As Krugman notes:
Many economists will find these changes deeply disturbing. It will be a long time, if ever, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. To some economists that will be a reason to cling to neoclassicism, despite its utter failure to make sense of the greatest economic crisis in three generations. This seems, however, like a good time to recall the words of H. L. Mencken: “There is always an easy solution to every human problem — neat, plausible and wrong.”
When it comes to the all-too-human problem of recessions and depressions, economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly. The vision that emerges as the profession rethinks its foundations may not be all that clear; it certainly won’t be neat; but we can hope that it will have the virtue of being at least partly right.
This is the economics we need.
It’s Keynesian (not, I stress neo-Keynesian or New Keynesian — they’re not Keynesian). It’s Keynesian.
Now let’s get on with it.
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“And he criticises the Efficient Market Hypothesis Tim Worstall has declared so obviously true he cannot see how anyone can doubt it:”
Richard, please….I said that the weak to medium version is so obviously true that. Fama is a proponent of the strong version. They are very different things indeed. Krugman, DeLong (also mentioned) and yes, Keynesian economists like John Quiggin over at Crooked Timber would all agree that the weak version is simply a statement of obvious fact.
“a bubble correctly diagnosed by behavioral economists like Robert Shiller of Yale, who related it to past episodes of “irrational exuberance””
Shiller is (rightly) praised a number of times by Krugman. But if you actually knew some economics then you’d find that you really, really, do not like Shiller’s views at all. For his argument is that the housing boom was caused by an insufficient development of markets. Specifically, that there is no futures market where people can go short on house prices. Yes, I am being serious: he states that the way to make sure it does not happen again is to have *more* speculation, not less.
And his analysis is strongly grounded in the (weak to medium) version of the EMH. The information available to the market did not include the fact that many people thought there was a boom in housing. For the markets had no method by which those boomsters could, with their money, make their views known. Thus, if we had had (and in future do have) futures and options in housing, so that people can indeed speculate upon a fall in house prices, those views will indeed influence market prices and thus the boom will not happen: or at least be mitigated.
To use Shiller to disprove the (weak to medium) version of the EMH when Shiller actually uses the (weak to medium) EMH as the bedrock for his solution is simply ignorant on your part.
You really do not know your economics, do you?
Tim
Thought you’d rise to the bait, and deliver an ad hominem attack
So let’s be clear: as I said, I may be wrong, but I don’t think Krugman is
If he’s right all your economic logic falls apart
Now which option would you prefer Tim?
Richard
if I remember correctly then Shiller wrote that the bubble was provocated by state intervention in the housing market and thus the market was intentionally distorted.
“I like the theory of efficient financial markets as much as anyone.”
Paul Krugman, article in Fortune, 1997.
As I’ve tried to point out to you several times, there is no one “efficient markets hypothesis”. There are a series of them, from weak (which just about every ecnomist would endorse) to strong (which Fama proposes and which Krugman is attacking).
If you’er not prepared to diffrentiate between these then you shouldn’t be discussing the subject: because the discussion is not about whether the EMH is valuable or correct, it is which version of it is.
Richard,
I would suggest to anyone, read Krugman (the book version) versus Krugman (the columnist version). The two are quite different in both tone and substance. The former being readable and thought-provoking (note, not necessarily the same as thought agreeing). The latter being populist babble churned out to give some sort of quasi-intellectual heft to the statists milling about on the fevered left.
Generally speaking….
Georges
sorry, it should be “provoked” not “provocated”.
“First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds.”
The real problem I have with this statement is not that I fundamentally disagree with it, but that there is a tacit implication that if you take the potentially irrational human and put him in government, he suddenly, for some unexplained reason, stops being irrational and becomes omniscient, benevolent and perfectly rational.
I don’t think anybody would claim that people are always totally rational, but as soon as you accept that people can act according to delusion and irrationality, it still makes more sense to disperse power among people via a free market than to centralise it in a small group, where, for example, one person may be so deluded as to believe that they have single-handedly put an end to the cycle of boom and bust, causing immense damage in the process by acting on that delusion.
Paul Krugman’s New York Times article is good, but his recent LSE Robbins lecture “The night they re-read Minsky” (http://www.lse.ac.uk/collections/LSEPublicLecturesAndEvents/events/2009/20090311t2003z001.htm) is even better, and well worth listening to, as it includes a lot of detail that had to be cut out of the NYT article.
Basically Krugman’s contention is that US academia has, for 25 years or more, been divided roughly into “freshwater” and “saltwater” economists. The “freshwater” schools, centering around Chicago, include people like Eugene Fama – die-hard free-marketeers who would mostly embrace ‘strong’ EMH. The “saltwater” schools – places like Harvard, Yale, Berkeley, UCLA – mainly comprise the so-called “New Keynesians” who would be comfortable with weak EMH but not strong EMH. But Krugman is clear that even the saltwater group (which he was a contented member of for several decades before moving to a more radical position in the last few years) seriously underestimated the potential for systemic instability in the US economy. It was only really the radical post-Keynesian economist Hyman Minsky and a few others in the US (e.g. UCLA economic historian Robert Brenner) who really identified systemic instability as a disaster waiting to happen. Most of the rest of the profession didn’t have a clue. Even Shiller, who was a fairly mainstream critic of the internet and housing bubbles, was vilified as some kind of nutjob by most of the profession – including the “saltwater” economists – until his predictions came true.
The lesson? Mainstream economists in the US (and most other industrialised countries) of every stripe need to eat several tons of humble pie – and as Skidelsky said in the article Richard blogged recently, academic economics needs to be reconstructed – not completely from scratch, but several years in the operating theatre, for sure.
Tim
I rather think you’ve met your match in Howard
And I note you go back to 1997 to find your material – since when Krugman openly admits he has changed his mind
Not revealing a lot of integrity here, are we Tim?
Richard
PS Thanks Howard
Paul
Free markets do not diversify power
They concentrate it in the hands of a very, very few becasue the votes are not evenly distributed
Your argument is utterly wrong
Richard
Georges
I’ve read the books
You’re, by and large, right
Richard
“I rather think you’ve met your match in Howard”
Gosh, have I?
“The “freshwater” schools, centering around Chicago, include people like Eugene Fama – die-hard free-marketeers who would mostly embrace ’strong’ EMH. The “saltwater” schools – places like Harvard, Yale, Berkeley, UCLA – mainly comprise the so-called “New Keynesians” who would be comfortable with weak EMH but not strong EMH.”
That’s Howard.
“Richard, please….I said that the weak to medium version is so obviously true that. Fama is a proponent of the strong version. They are very different things indeed. Krugman, DeLong (also mentioned) and yes, Keynesian economists like John Quiggin over at Crooked Timber would all agree that the weak version is simply a statement of obvious fact.”
That’s me.
If you think that someone agreeing with me is my meeting my match then there’s something seriously wrong with your logical skills Richard.
Note, please, the very strong distinction made between “weak EMH” and “strong EMH”. A point I have made here several times.
Note, please, that unless you make that distinction you’re not, as I’ve said here, understanding the debate.
Tim
There’s a problem with believing you believe in weak EMH
Have I noted your call for a fiscal stimulus package of direct government spending?
Have I noted your call for more regulation?
Now I readily admit I ignore most of what you write, but I haven’t seen you out there thumping the tub for the Green New Deal.
So why the claim you’re not in the strong EMH camp?
And let’s also face facts: EMH assumes all events can have probabilities attached. I don’t agree. I think there isn’t just risk, there is uncertainty. If so – tell me how EMH works? And why in that case it is true?
Richard
Richard: “Free markets do not diversify power. They concentrate it in the hands of a very, very few becasue the votes are not evenly distributed. Your argument is utterly wrong”
I’m afraid it isn’t, Richard. Power, while not being evenly divided in a free market situation, will always be far more diversified than when power is overwhelmingly wielded by an over-mighty centralised state.
I might not have as much money as some others, but at least in a free market situation, I have some meaningful control over my own life because:
(a) My money has value to the people I can give it to, whereas my vote, by virtue of the “safe” parliamentary seat I live in, doesn’t. It’s all very well saying that votes are evenly distributed, but my vote has minuscule value compared to that of somebody in a marginal.
(b) The people who want our money value every pound of it equally. It doesn’t get treated as valueless by people who have a certain amount of it, as opposed to a politician who has already reached a majority.
(c) Perhaps most importantly, I always have some measure of control in a free market, as I vote with my pound every day, as opposed to parliamentary voting, which is the equivalent of being forced to choose someone who will then decide how I must spend my money for the next four years and of course, the person who gets to spend my money might not actually be the person I wanted.
And that aside, only a fool would try to claim that governments do not tend to serve the interests of their sponsors. It will always be easier to use wealth to corrupt a handful of politicians who hold all the power than it will to manipulate an entire population of people operating relatively autonomously.
Dare you put aside your dogma and embrace the facts, Richard?
Paul
I have faced facts
On the basis opf facts I formed an opinion
On the basis of dogma you formed yours
Now who has closest relationshiop to reality?
And whose ideas are of most use to other people – yours based on self interest, or mine based on the well-being of populations?
Sorry Paul – but leave your fantasy behind
Only then can you usefully contribute to debate
Richard
I am just grateful that there are people like you
who give these matters like taxes, especially inheritance taxes of late, serious analysis. This is a serious matter that needs to be addressed appropriately, not by run of the mill types, but experts. You have been very informative.
It explains why in a recession like this, government is between a rock and a hard place while everyone is crying out
loud and rocking the boat. We are not going anywhere away
from all these confusion. Naturally, government has to dip
its fingers into erstwhile untaxed grounds to raise money.
Everyone has enjoyed the minimal tax levied on inheritance
for long years. Then, the matter of health care has again been raised and everyone is raising hell. Can’t someone be
sober and sort these thing out? Let us leave it to experts
to address the problem.
“And whose ideas are of most use to other people – yours based on self interest, or mine based on the well-being of populations?”
Oh, that’s an easy one. The unique feature of the combination of capitalism and free markets that we started using around 1750 is that it provides real, sustained, rises in the standard of living for the average member of the society. No other method of economic organisation has managed that. Even Marx pointed that out in The Communist Manifesto.
Enlightened self-interest wins out over altruism for the well being of populations, we’ve tested that idea for 250 odd years now and self-interest very definitely wins.
Tim
Enlightenmded self interest
Ah, you mean the sort that exists within the confines of regulation promoted by a democratic state acting in the interests of all, not the minority
We agree then
Richard
Richard
Do you really have nothing better to offer than that silly self-interest canard?
I had hoped that if you still disagreed with my points you might try to offer some counter-arguments. Clearly I over-estimated you.
Paul
You assumed I had time to spend debating with you
That was your error
And candidly – I also said all that was needed
Richard
Free markets cannot exist unless land is free. Otherwise the power is with those who own land.
“There’s a problem with believing you believe in weak EMH”
OK, what is that?
“Have I noted your call for a fiscal stimulus package of direct government spending?”
What has that to do with EMH? Absolutely nothing, you cannot judge my beliefs about EMH by my support or not for direct stimulus for the two are not connected.
As it happens I’m a fan of the various “extraordinary measures” that have been taken as we approach the zero interest rate bound. Printing money, QE and so on, all entirely sound monetarist reactions to a falling velocity of money in the MV=PQ equation, for we definitely do not want to have a general falling of P, that’s deflation.
But none of that has anything to do with EMH.
“Have I noted your call for more regulation?”
No, for I don’t think we need more regulation. Different regulation perhaps, get rid of the tripartite system maybe, possibly even the creation of new speculative markets (as Shiller proposes) so that we have complete markets rather than the current incomplete system (this isn’t as absurd as it sounds, cap and trade of CO2 is just that, the creation of markets where there was not one before) but again, this has nothing to do with my views on EMH.
“Now I readily admit I ignore most of what you write, but I haven’t seen you out there thumping the tub for the Green New Deal.”
Of course not: when it first came out I wrote a number of pieces pointing out that the basic premises were insane. Just as an example, there’s a call for capital controls and a lowering of interest rates in order to increase the amount of capital to spend on long term climate change reducing projects.
There’s a number of problems with that idea. The first is that of course governments don’t control long term interest rates. They can influence them a little bit through their control of base rates, but long term rates are set by the markets. If government were to try and set long term rates by legislative fiat and then they set them too low, all that would happen is that there would be less savings and thus less capital to invest.
Indeed, lowering interest rates to 3% as suggested would have this effect anyway. Then there’s the capital controls part. Sure, this would mean that savings generated within the country would not be able to leave. But we’ve been running trade deficits for most of the last few decades. As the current and capital accounts must balance (for the balance of payments must indeed balance) this means that we’ve been importing capital for decades. Foreigners simply won’t send their money in if they can’t then take it out again so capital controls will inevitably reduce the amount of capital coming in and thus the amount available for investment in pet green schemes.
That’s why I not only don’t thump the tub for the Green New Deal I actively reject it. For the proposals to increase the amount of capital available for investment are guaranteed to reduce the amount of capital available for investment. It’s counter-productive nonsense in short.
“So why the claim you’re not in the strong EMH camp?”
Because you are failing to understand what the EMH is. To go over it once again.
The weak version simply states that in a market, market prices reflect the information available to the participants in that market.
That’s it. There are a number of implications, that in the absence of either new information or of information held that is not generally available to the market, it is impossible to beat that market consistently over time.
The strong version says that all information is encompassed in market prices.
“And let’s also face facts: EMH assumes all events can have probabilities attached. I don’t agree. I think there isn’t just risk, there is uncertainty.”
That would be a very strong version indeed: one which stated that information that we don’t know yet, that no one does, that uncertainty is encompassed into market prices. And no one that I have heard of makes that claim. No, not even Eugene Fama.
The weak version holds though: market prices reflect what we know about the world. When new information comes along (for example, a general decline in house prices across most of the USA: remember, this is something that had never happened before, the assumption was that it was still a series of largely unconnected regional markets as it always had been) then prices will change.
There’s nothing mysterious about the weak EMH, it’s simply an obvious statement of a truism. Market prices reflect what people in the market know about what affects market prices.
Pretty simple really.
Tim
For your truism to be true we have to assume that information is relevant and unbiased
If it is not – and the existence of advertising shows it is not – and the existence of tax havens shows it is asymmetric, then EMH may be true isn the narrow confines you describe – but so what – it is utterly useless at predicting behaviour?
In which case, what use is it?
A tautology proves nothing. And as Krugman notes, proving that a 2L bottle of ketchup costs twice that of a 1l bottle does not prove ketchup is properly priced.
In other words – the constraints of your assumptions make the economics you espouse valueless in use
Richard
“Ah, you mean the sort that exists within the confines of regulation promoted by a democratic state acting in the interests of all, not the minority”
We agree if we agree upon the meanings of “confines of regulation”, “democratic state”, “interests of all” and “minority”.
Which I don’t think we do in fact.
but how do you manage an economy if people’s behavior is unpredictible and all information is distorted (i.e. somebody assumes that even a weak market efficiency hypothesis does not work)?
“For your truism to be true we have to assume that information is relevant and unbiased”
No, we don’t.
“In which case, what use is it?”
It’s a little difficult trying to conduct an economics semiar in your comments section. Please go and read up about the EMH. The wikipedia entry is pretty good on it. There are a number of useful implications that stem from it.
“And as Krugman notes, proving that a 2L bottle of ketchup costs twice that of a 1l bottle does not prove ketchup is properly priced.”
Actually, that’s Larry Summers as quoted by Krugman. And if you go and actually look at the supermarket shelves you’ll note that a 2 L bottle is not twice the price of a 1L.
“In other words – the constraints of your assumptions make the economics you espouse valueless in use”
As you’ve not bothered to find out what the implications of the EMH are how can you state whether it’s useful in practice or not?
For example, one implication is that unless you’ve got new information unknown to the rest of the market then you’re not going to be able to beat that market (on anything other than a random basis) over time. That’s n extremely useful lesson for retail investors. Don’t invest with active managers, don’t try to stock pick yourself, just stick the money in a low fee index linked fund and leave it there.
This does provide better returns over the decades than either an active manager or self-management. That’s an extremely useful thing to know, isn’t it?
“For your truism to be true we have to assume that information is relevant and unbiased. If it is not – and the existence of advertising shows it is not.”
And the existence of lobbying and Ministers having meetings with special interest groups on yatchs in the Med shows the same applies to the state.
That is the crux of the problem, Richard. For every potential flaw you can highlight within a market situation, the flaw is invariably implified if you replace the market by concentrating power in a very small point within the state.
Unfortunately PaulL appears to be spot on. Wasn’t Mandy on board with Deripaska, part of the consortium which has bought GM Europe? There was PM today saying he had assurances that Vauxhall jobs are safe. Or have I got my Russian oligarchs mixed up?
Carol, correct oligarch. Deripaska owns Gaz which was part of the consortium. It is assumed that Gaz will end up as the buyer for the Sberbank equity stake.
And the Russian oligarchs provide a very good example of the problem that Paul is talking about, the concentration of economic power into the State. When that happens, those in favour with the State get all the economic goodies. Those that try to oppose those running the State get….well, I hope everyone remembers what happened to Khordokovsky? Bankrupted and jailed because he started funding anti-Putin politicians?
Tim
I find it very odd that a state corrupted by over-enthusiastic imposition of a market should be sued by you as an example of a place where the state has too much power
Amazing how useful Russia has been to the Right
Once you used to say anyone further left than UKIP should move there
Now you say it is an example of state abuse when it is actually an example of market failure
What’s the next straw man?
Richard
“Once you used to say anyone further left than UKIP should move there”
Err, no Richard. I’m the one who did live there for seven years….or didn’t you know that?
“Now you say it is an example of state abuse”
Sure, it most certainly is an example of where the State, in the person of those few politicians at the centre of power, has way too much power over the economy.
Tim
So we’ve got you to blame for the mess
At last I’ve found a use for you!
Richard
Why this assumption that the economic paradigm hasnt worked?
Its worked perfectly for those who have promoted it throughout. The rich have got richer, and other people’s lives have became much more insecure, including workers losing many years of traction in the labour standards that had been achieved, so are now much more vulnerable. Combined with movement of cheap labour, the rebalancing of powers has gone very much in favour of employers and big business.
If there is something wrong with that then here is a primary, necessary stage of considering aims, and whose aims, before dismissing the economic system as a failure.
And Krugman has certainly done his share in promoting free market and doing very well out of that, himself, too
russia is not an example of market failure. it is an example of immense corruption where no clear borders exist between the state, economy and criminals.
Albert Dreyfuss
Experts are part of the problem. Ed Balls (Oxford and Harvard) was one of the brightest economists of his generation and the brains behind Gordon Brown. Yet between them they ran policies which not only put Britain in a poor state to deal with the bust, but actually made the UK a major contributor to the trouble.
Why not become your own expert? Take nothing that you hear or read for granted as being true. Most of it is a mixture of nonsense laced with a few half-truths. Question everything people hear or say.
“So we’ve got you to blame for the mess”
Most droll….but no, I was just making a living there. It was Richard Layard advising the Russian Government (yes, that Richard Layard) so take it up with him.
I wonder if people at The Guardian read this blog?
http://www.guardian.co.uk/science/2009/sep/15/brainfood-economics-banking?
“But that still leaves the first part of EMH intact; that you can’t beat the market unless you have insider information. It implies that most of us are better off stowing our savings in a cheap fund that tracks the stock market, rather than with some expensive smarty-pants fund manager. There you go, an idea from economics that might save you money: who’d have thought it?”
Remarkably similar to what I wrote above isn’t it?
And, yes, the weak version of the EMH does indeed both hold and have interesting lessons for us.