The Crisis: A Failure or a Vindication of Economics?

Today was the first lecture of thirty-five or so lectures I will give this fall in Stanford’s Economics 1, the namesake of this Blog. Enrollment is way up. The financial crisis is naturally generating a great deal of interest in economics.

In the meantime, the financial crisis is generating a great deal of hand-wringing and debate among economists about their subject. This summer a cover of The Economist magazine shows a book titled “Modern Economic Theory” melting into a puddle to illustrate “What Went Wrong with Economics.” It was the most talked about issue of the year. This is an important debate, and the different positions deserve to be covered in the basic economics course.

Some economists are calling for a complete redo of economics—or for a return to a version of the subject popular thirty years ago. They say that economics failed to prevent the crisis or even led to it. Many of these economists argue for a more interventionist government policy, saying that John Maynard Keynes was right and Milton Friedman was wrong. Paul Samuelson was one of the first to speak out this way, saying in January in an interview in the New Perspectives Quarterly (Winter 2009), “today we see how utterly mistaken was the Milton Friedman notion that a market system can regulate itself… This prevailing ideology of the last few decades has now been reversed…I wish Friedman were still alive so he could witness how his extremism led to the defeat of his own ideas”. Paul Krugman’s longer piece two weeks ago in the New York Times Magazine (September 7, 2009) started off another round of debate. He faults modern economics (espeically modern macroeconomics) for bringing on the crisis. He says it focuses too much on beauty over practicality and does not recognize the need for more government intervention to prevent and cure the crisis. His fix is to add more psychology to economics or to build better models of credit.

But there are other opposing views to cover. In my view, the financial crisis does not provide any evidence of a failure of modern economics. Rather the crisis vindicates the theory. Why do I say this? Because the research I have done shows that the crisis was caused by a deviation of policy from the type of policy recommended by modern economics. It was an interventionist deviation from the type of systematic policy that was responsible for the remarkably good economic performance in the two decades before the crisis. Economists call this earlier period the Long Boom or the Great Moderation because of the remarkably long expansions and short shallow recessions. In other words, we have convincing evidence that interventionist government policies have done harm. The crisis did not occur because economic theory went wrong. It occurred because policy went wrong, because policy makers stopped paying attention to the economics.