The Failure of Economics

[Toro]

A great read by Paul Krugman. A few exerts below.

Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy. During the golden years, financial economists came to believe that markets were inherently stable — indeed, that stocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year. ...

Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation. ...

Keynes considered it a very bad idea to let such markets, in which speculators spent their time chasing one another’s tails, dictate important business decisions: “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” By 1970 or so, however, the study of financial markets seemed to have been taken over by Voltaire’s Dr. Pangloss, who insisted that we live in the best of all possible worlds. Discussion of investor irrationality, of bubbles, of destructive speculation had virtually disappeared from academic discourse. The field was dominated by the “efficient-market hypothesis,” promulgated by Eugene Fama of the University of Chicago, which claims that financial markets price assets precisely at their intrinsic worth given all publicly available information. (The price of a company’s stock, for example, always accurately reflects the company’s value given the information available on the company’s earnings, its business prospects and so on.) ...

Finance theorists continued to believe that their models were essentially right, and so did many people making real-world decisions. Not least among these was Alan Greenspan, who was then the Fed chairman and a long-time supporter of financial deregulation whose rejection of calls to rein in subprime lending or address the ever-inflating housing bubble rested in large part on the belief that modern financial economics had everything under control. There was a telling moment in 2005, at a conference held to honor Greenspan’s tenure at the Fed. One brave attendee, Raghuram Rajan (of the University of Chicago, surprisingly), presented a paper warning that the financial system was taking on potentially dangerous levels of risk. He was mocked by almost all present — including, by the way, Larry Summers, who dismissed his warnings as “misguided.” ...

Take, for example, the precipitous rise and fall of housing prices. Some economists, notably Robert Shiller, did identify the bubble and warn of painful consequences if it were to burst. Yet key policy makers failed to see the obvious. In 2004, Alan Greenspan dismissed talk of a housing bubble: “a national severe price distortion,” he declared, was “most unlikely.” Home-price increases, Ben Bernanke said in 2005, “largely reflect strong economic fundamentals.” ...

But there was something else going on: a general belief that bubbles just don’t happen. What’s striking, when you reread Greenspan’s assurances, is that they weren’t based on evidence — they were based on the a priori assertion that there simply can’t be a bubble in housing. And the finance theorists were even more adamant on this point. In a 2007 interview, Eugene Fama, the father of the efficient-market hypothesis, declared that “the word ‘bubble’ drives me nuts,” and went on to explain why we can trust the housing market: “Housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed.”

Indeed, home buyers generally do carefully compare prices — that is, they compare the price of their potential purchase with the prices of other houses. But this says nothing about whether the overall price of houses is justified. It’s ketchup economics, again: because a two-quart bottle of ketchup costs twice as much as a one-quart bottle, finance theorists declare that the price of ketchup must be right.

In short, the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in inflating that bubble in the first place. ...

 

[CrusaderFrank]

Paul Krugman is a perfect contra-indicator. He's the Wrong Way Corrigan and Professor Backwards. I have never read a guy more out of touch with reality and so totally wrong about economics.

HOW DO YOU HAVE "FREE MARKETS" WHEN YOU HAVE CRA, FREDDIE AND FANNIE DICTATING WHAT BANKS MUST LOAN?

HOW DO YOU HAVE FREE MARKETS WHEN DEMOCRATS CONTINUE TO STEER FREDDIE AND FANNIE OFF THE CLIFF TAKING THE US HOUSING MARKET DOWN WITH THEM?

 

[Toro]

Except that the CRA had little to do with the housing debacle and the GSEs a minor part.

http://www.usmessageboard.com/economy/70006-cra-not-to-blame-for-housing-debacle.html

 

[del]

"if you laid all the economists in the world end to end, they still wouldn't reach a conclusion."- author unknown (to me, anyway)

 

[Shogun]

Toro, you may recall how I feel about free market capitalistas and their quickness to be wrong while clinging to theoretical bullshit as justifications for errors. I'm glad to see that it's possible for some to see the flaw in such blind pompousness after all.

 

[Toro]

Empiricism > ideology

 

[CrusaderFrank]

Except that the CRA had little to do with the housing debacle and the GSEs a minor part.

http://www.usmessageboard.com/economy/70006-cra-not-to-blame-for-housing-debacle.html

My aunt once told me, "Frank, never take advise from people who don't know what the fuck they're talking about."

She was a very wise lady

 

[del]

"if you laid all the economists in the world end to end, they still wouldn't reach a conclusion."- author unknown (to me, anyway)

"in the long run, we're all dead"- j.m. keynes

 

[Big Black Dog]

Things are tough all around. Mrs. BBD failed to hand over my allowance this week... If she doesn't come across pretty soon I'm going to have to start pulling some funds out of my "secret sock" that I keep hidden behind the War and Peace book on the bookcase in the library. I move the "secret sock" every week to a new location so none of you bozos try to sneak in on me and leave me "sockless".

 

[Kevin_Kennedy]

"They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts" - Krugman

This quote has me confused. Krugman called for the Fed to create a housing bubble after the dot-com bust to pull us out of the recession, but now he implies that irrationality in the market creates bubbles? Since the Federal Reserve is the anti-thesis to the free market how does Krugman come to this conclusion?

I think Jeffrey Tucker of the Mises Institute had an interesting response to this article.

It's Krugman's lastest manifesto in the NYTMag. It's all here: how economists were in love with capitalism before the Great Depression (?), how Keynes was the only one who saw the failures of laissez-faire (!), how economists fell in love again with markets in recent years (!!), and how the popping bubble has startled them whereas the great Keynesian Krugman knew it all along (??). Oh, and by the way, there is no one who ever existed named Hayek or Mises or Haberler or their students.

The whole thing reads like a big fairytale, and the author is the hero in the end.

You don't want to read this - Mises Economics Blog

 

[Toro]

Except that the CRA had little to do with the housing debacle and the GSEs a minor part.

http://www.usmessageboard.com/economy/70006-cra-not-to-blame-for-housing-debacle.html

My aunt once told me, "Frank, never take advise from people who don't know what the fuck they're talking about."

She was a very wise lady

I would agree with her.

That's why people who think the CRA and the GSEs caused this mess aren't taken seriously by people who do this for a living.

 

[Toro]

"They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts" - Krugman

This quote has me confused. Krugman called for the Fed to create a housing bubble after the dot-com bust to pull us out of the recession, but now he implies that irrationality in the market creates bubbles? Since the Federal Reserve is the anti-thesis to the free market how does Krugman come to this conclusion?

When did Krugman call for the creation of a housing bubble? Can you supply a link? That would be interesting.

Irrationality in the market does cause bubbles. If people were rational, they would have seen this graph

and realized that the housing market was absolutely insane.

It was not hard to see the bubble in housing. And it wasn't hard to see all the irrationality all around when it was occurring.

 

[Kevin_Kennedy]

"They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts" - Krugman

This quote has me confused. Krugman called for the Fed to create a housing bubble after the dot-com bust to pull us out of the recession, but now he implies that irrationality in the market creates bubbles? Since the Federal Reserve is the anti-thesis to the free market how does Krugman come to this conclusion?

When did Krugman call for the creation of a housing bubble? Can you supply a link? That would be interesting.

Irrationality in the market does cause bubbles. If people were rational, they would have seen this graph

and realized that the housing market was absolutely insane.

It was not hard to see the bubble in housing. And it wasn't hard to see all the irrationality all around when it was occurring.

I'll look for the exact quote.

This so-called irrationality in the market was brought about by Federal Reserve policy, and the Federal Reserve would not exist in a free market.

 

[Kevin_Kennedy]

Here's Krugman calling for the Federal Reserve to create a housing bubble by keeping interest rates low following the dot-com bust.

Krugman Did Cause the Housing Bubble - Mises Economics Blog

 

[Toro]

Here's Krugman calling for the Federal Reserve to create a housing bubble by keeping interest rates low following the dot-com bust.

Krugman Did Cause the Housing Bubble - Mises Economics Blog

Actually, that's not what he said, unless I missed it in there somewhere.

What he said - or at least what I read he said - was that the Fed should keep interest rates to low to spur housing, not to create a bubble. A bubble, indeed, is what happened, but that is not what Krugman was calling for. In fact, Krugman's thinking was mainstream thinking at the time.

Instead, the low interest rates created enormous unintended consequences (though low interest rates were not the only reason for the debacle). The title of this thread is "The Failure of Economics." I think you can argue with your link that Krugman himself demonstrated the failure of economics.

I saw Krugman on Meet the Press a few months ago say that low interest rates had little to do with the bubble. I think he is wrong, and it is convenient for him to say this when he was calling for low interest rates.

I also think the government and the Fed are repeating the mistakes of earlier this decade, and we are likely to recreate bubbles elsewhere, though it likely to be less big than the housing bubble since we do not have the same transmission mechanisms to facilitate the flow of credit as the shadow banking system has imploded. But I think something big is coming, and I think it could be gold, which I own a lot of.

 

[Kevin_Kennedy]

Here's Krugman calling for the Federal Reserve to create a housing bubble by keeping interest rates low following the dot-com bust.

Krugman Did Cause the Housing Bubble - Mises Economics Blog

Actually, that's not what he said, unless I missed it in there somewhere.

What he said - or at least what I read he said - was that the Fed should keep interest rates to low to spur housing, not to create a bubble. A bubble, indeed, is what happened, but that is not what Krugman was calling for. In fact, Krugman's thinking was mainstream thinking at the time.

Instead, the low interest rates created enormous unintended consequences (though low interest rates were not the only reason for the debacle). The title of this thread is "The Failure of Economics." I think you can argue with your link that Krugman himself demonstrated the failure of economics.

I saw Krugman on Meet the Press a few months ago say that low interest rates had little to do with the bubble. I think he is wrong, and it is convenient for him to say this when he was calling for low interest rates.

I also think the government and the Fed are repeating the mistakes of earlier this decade, and we are likely to recreate bubbles elsewhere, though it likely to be less big than the housing bubble since we do not have the same transmission mechanisms to facilitate the flow of credit as the shadow banking system has imploded. But I think something big is coming, and I think it could be gold, which I own a lot of.

Low interest rates create bubbles, however, and he was certainly calling for that. So for him to then attribute the bubble to irrationality in the market is dishonest, when he advocated for the policy that created the bubble in the first place.

 

[Paulie]

I love how guys like Krugman, who are considered to be GENIUSES by many, can all the sudden be forgiven for their inability to have seen what was obvious to so many others...as if NOW they were capable of making that kind of mistake, but never before.

History has proven that artificially low interest rates can cause problems. The graph that Toro posted of historical housing prices was available to any and all of the genius economic minds.

Why is it that the Keynesians didn't see it coming, but the Austrians did? The Keynesians never admit they were wrong, and they always go back to the same policies.

I agree that there were other factors in the entire financial system collapse than just the low interest rates. But the general run-up in home prices really couldn't be attributed to anything other than the interest rates. How else do you get that many people to indebt themselves like that? You dangle the carrot in front of their faces, that's how. The carrot was the historicalyl low interest rates, coupled with the fact that the market just steadily continued to rise from all of the people buying...and it just looked like an opportunity for ANYONE, really.

Without the low rates, the home price inflation could not have possibly happened like it did. The beginning of the run-up in prices perfectly coincides with the timing of the interest rate reduction down to 1%. In fact, right around where the previous price peaks were in that graph, is where the rate hit 1%. So where it SHOULD have stopped, it kept going instead, because the market was ripe for 'infinite' gains.

Don't get me wrong though, I blame the people just as much. Most aren't wise enough to understand bubbles, and price trends, etc. All they see is "historically low rates!!!" "Get in now!!!" And then they see their Federal Reserve chairman, who is SUPPOSED to be someone to trust, saying "take advantage of the low rates!! Buy a house! Take out a home equity loan, even!!!"

 

[midcan5]

Low interest rates have little to do with bubbles. Bubbles drive themselves through a wish and a desire to earn great sums of money through little effort. It is sort of ironic that high interest rates were Nixon/Ford/Carter's downfall and now the opposite is true. Shows how much anyone knows.

The keys to collapse were deregulation and lots of money chasing the greedy dog's tail. When Bush Jr experienced the recession after the Internet bubble, his solution was tax breaks. Instead of rebuilding the nation, helping the infrastructure, and assisting entitlement programs he choose to give it away to the wealthy who went bonkers speculating and wanting more. In the end human nature is the fault but that is true of all stupidity. The bible was right, money is the root and the cause of all evil. Consider how often the wackos mention 'taxes' and you know the case for sanity is lost.

Markets would be great if it weren't for people. Trouble is without people no market, so there is the bind. Unsolvable - thus strong regulations and ethical standards. "Capitalism is the astounding belief that the most wickedest of men will do the most wickedest of things for the greatest good of everyone."*

"The proximate cause of the financial crisis that has now engulfed the world and led to serious recession in the United States was the bursting of the housing bubble. But the true cause was the anti-government ideology that developed in the 1970s, solidified during the Reagan presidency, and was carried to extremes in recent years by Republicans and, to a significant degree, by Democrats as well. The nation’s economic and political health now depend not on substituting an old ideology for a new one, but on freedom from these ideological restraints and on the pragmatic, robust use of government." Boston Review — Jeff Madrick: No New Tax Cuts

"Charles Morris's informed and unusual book, The Trillion Dollar Meltdown, provides a decisive rebuttal to all such excuse-making and blame of "government." Morris makes it clear that it was an unquenchable thirst for easy profits that led commercial and investment banks in the US and around the world—as well as hedge funds, insurance companies, private equity firms, and other financial institutions—to take unjustifiable risks for their own gain, and in so doing jeopardize the future of the nation's credit system and now the economy itself. In fact, government-sponsored entities, Fannie Mae and Freddie Mac, did have a part in the crisis, but not because they were principally trying to help the poor buy homes. Rather, they were also trying to maximize their profits and justify large salaries and bonuses for their executives. They had been made into publicly traded companies in 1989." How We Were Ruined & What We Can Do - The New York Review of Books

"From that moment, Whitney became E.F. Hutton: When she spoke, people listened. Her message was clear. If you want to know what these Wall Street firms are really worth, take a hard look at the crappy assets they bought with huge sums of borrowed money, and imagine what they’d fetch in a fire sale. The vast assemblages of highly paid people inside the firms were essentially worth nothing. For better than a year now, Whitney has responded to the claims by bankers and brokers that they had put their problems behind them with this write-down or that capital raise with a claim of her own: You’re wrong. You’re still not facing up to how badly you have mismanaged your business." The End - News Markets - Portfolio.com


*John Maynard Keynes

It was Shaw.

"If all economists were laid end to end, they would not reach a conclusion." George Bernard Shaw

 

[mascale]

John Kenneth Galbraith used to acknowledge that the Reagan Deficits weren't Keynesian-inspired. More recently, anyone with a Swedish Guilt Money prize would further look to the effects of fiscal policy, when lowering interest rates.

There's no bubble when the tax rates create infrastructure, non-financial services, employment. In fact, even Social Security gets repaid, and even MediCare costs get controlled. There are actually other jobs to do, including preventive kids of employment.

The Republican Conservatives, and the Ivy League,--and the Guilt Money prizewinners--all relied heavily on the Financial Services. Even Vice President Biden, then a Senator, could point out that even the military spending had no relationship to the requirements in the field.

The Economy was Conservative, Republican, eventually Cross-over GOP. Even now everyone is getting when-they-gain-exclusively-screwed. The Stimulus money projects went directly too often, to the states, unable to provide their needed projects on their own. Large sectors of the economy are being by-passed, even now.

That, however, is Ivy League and Prize Money stuff. That is failed fiscal policy, and is not interest rates at whatever it is they think they are doing(?): Apparently starving(?)!

Crow: James Crow: Shaken, Not Stirred!"
(Clearly, not that anyone seriously believes that law has anything to do with economics!)

 

[Polk]

HOW DO YOU HAVE "FREE MARKETS" WHEN YOU HAVE CRA, FREDDIE AND FANNIE DICTATING WHAT BANKS MUST LOAN?

None of those things dictate loan terms to banks.