How Did Economists Get it So Wrong?

Paul Krugman, winner of the 2008 Nobel Prize in Economics, trying to answer How Did Economists Get it So Wrong? says they mistook beauty for truth. Their models did not allow for the kind of collapse that happened last year.

A similar shattering of faith in the prevailing economic theories of the day accompanied the Great Depression of the 1930s. Then, as now, the academic discipline (so-called neoclassical economics) failed to anticipate or account for the latest financial crisis.

Cometh the hour, cometh the man, and the man of economics' darkest hour was John M. Keynes.

Keynes did not have a convincing explanation for what caused the Depression (Krugman is not much help either, saying merely that economists of tomorrow must 'face up to the inconvenient reality [of]...extraordinary delusions and the madness of crowds') but his theory recommended that governments should spend on public works in order to cure it. This caught on and held sway until about 1960 in both academics, where a distinction between micro- and macro-economics started to be made, as well as in policy-making, where the government's role in the economy grew ever larger.

In the 1960s Milton Friedman led a revival of neoclassical economics by arguing that the cause of the Great Depression was bad central bank policy, so that there was, in fact, no need for wholesale revisions to pre-depression, pro-market theories. Governments should leave economies alone, and rely on monetary policy (e.g. loosening the money supply) to counteract slumps as soon as they emerged. This 'Chicago school' has steadily gained support over ever since, and both academic and practical economics have gradually retreated away from Keynes. For example, Ben Bernanke, our recently reappointed Fed Chairman, said on Friedman's 90th birthday in 2002: 'I would like to say to Milton and Anna [Schwartz, Friedman's coauthor]: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.'

The pendulum is now swinging Keynes' way again. But did Keynes have it right? Certainly , the debate on what caused the Great Depression continues.

And then there is possibility that the economists have got it really wrong, off chasing beautiful models instead of the truth.

Read this nice summary of the important foundational tenets of economics and chew on it:

Production takes place for consumption (derived from the Scot Adam Smith), not the other way round. Value is measured not as an average but at the margin (the Englishman W. S. Jevons, the Frenchman Leon Walras, and the Austrian Carl Menger). The cost of producing a commodity or service is not the labour required (the German Karl Marx) but the commodity or service thereby lost (the Austrian Friedrich von Wieser). The instinct of man is to “truck and barter” in markets (Adam Smith). He will find ways round, under, over or through restrictions created by government (the Austrian Eugen von Böhm-Bawerk). There is no such thing as absolute demand (for education, medicine or anything else) or supply (of labour or anything else) because both vary with price (the Englishmen Alfred Marshall, Lionel Robbins and many before and since). Not least, without the signalling device of price, man cannot spontaneously and voluntarily co-operate for prosperous co-existence (the Austrian Ludwig von Mises and the Austrian-born but voluntarily-British Friedrich Hayek).