In a New York Times op-ed, Paul Krugman offers his answer to the question of where economists erred in their treatment of the economic crisis.  (The article is lengthy and probably not all that interesting, but it does have a flow that keeps it going.)  While I may not be as educated in economics as Mr. Krugman, there were a number of points in the article that struck me as strange, lacking in context, or simply wrong.

For all the length and discussion, his basic answer to the topic question is that economists got it wrong by abandoning Keynesian economics.  Readers will find it unsurprising that his proposed solution going forward is to start thinking, again, more like Keynes.  In short, he believes that investors and economists came to rely too much on a view of financial markets which holds that they always get the right answer given the information available at the time, that “bubbles” are impossible, and that people in general can be counted on to act rationally.  Reality, he claims, is a lot more messy, and often needs to have the government involved to swim against the free market tide to bring stability to an otherwise unstable system and to head off the inherently bad problems of recession and unemployment.

The largest problem that I see with Mr. Krugman’s argument is that it ignores entirely one of the greatest destabilizing forces currently active in the market: The government itself.  Instead, Mr. Krugman appears to operate from the view that the current market is a largely untamed free market wilderness.  This position is not uncommon among liberals or other advocates of a centrally planned economy, who tend to label any market that does not behave as they desire as “free” (even such heavily regulated markets as health care) and in need of regulation.  In reality, it is hard to think of a market that hasn’t got a federal regulatory agency dedicated to it and which isn’t subject to countless regulations, not to mention the threat of lawsuit, even during “deregulation” periods.

Government meddling is certainly one factor which can, and likely does, cause “bubbles” to form in the economy.  A “bubble,” it has always appeared to me, is little more than a market response to incorrect or incomplete information which paints a rosier picture of the market than actually exists.  A bubble “bursting,” then, would simply be the market correcting itself once new information comes to light which points out investors’ exuberance.  In the late 1990s, the “tech bubble” grew from investor confusion as internet companies grew and appeared to succeed despite having no obvious business plan, strategy, revenue stream, or even product.  It burst when reality set in and people started to realize that traditional business rules applied to the web after all.  We know that the “housing bubble” was caused at least in part by the Fed driving interest rates (and, thus, mortgage rates) down and by the government pressuring lenders to make loans to people who had no financial business buying a house.  Here, too, something eventually had to give, especially once new government “mark to market”kicked in and eliminated any sense we might have had about how much anything might be worth.

Following any of the bubble bursts is a period which, as a matter of definition, we get to call a “recession.”  Whether or not this is bad would seem to mostly depend on whether or not recession values are more reflective of reality than the bubble values which preceded them.  If it is bad to live in the fantasy world of a bubble, it should be better to live in a post-bubble world where the value of things more closely reflects what the value ought to be.  Yet, Obama’s first reaction to the housing bubble collapse — of which Mr. Krugman seems to implicitly approve — was to exert government force to drive housing prices back up to their bubble levels, effectively locking in the bubble forever.

Of course, evidence so far suggests that even Obama’s Reality Distortion Field is not strong enough to pull that one off.  Despite the TARP money, the credit markets are still tight.  Despite the stimulus, unemployment continues to rise.  Despite bailing out GM and Chrysler, both companies still went bankrupt.  Despite every Keynesian action Obama has taken, he has utterly failed to produce a single long-term positive result for the economy as a whole.

So, how did economists get it wrong?  Well, Mr. Krugman certainly does have a point that it makes little sense to consider the correctness of housing prices by comparison to what other houses cost.  It also seems likely that they did put too much emphasis on the free market, neglecting to carefully analyze what effect government regulations were producing.  Whatever the conflicts within the economics community, we would seem to do ourselves no favors by pretending that central planning is any sort of economic panacea.

Tags: economics, free markets