Mainstream economists are trying to rewrite the history of the financial crisis in what is clearly becoming a poor attempt to claim they understood precisely what was going on. In a piece today Paul Krugman goes so far as to say that there wasn’t a lack of understanding. In fact, economists understood the crisis so well that their lack of involvement heading up to the crisis made things worse! This is all some strange version of revisionist history that amounts to little more than an attempt to protect the old guard of Mainstream Macro. Krugman says:
“the heterodox need to realize that they have, to an important extent, been working with the wrong story line.
Here’s the story they tell themselves: the failure of economists to predict the global economic crisis (and the poor policy response thereto), plus the surge in inequality, show the failure of conventional economic analysis. So it’s time to dethrone the whole thing — basically, the whole edifice dating back to Samuelson’s 1948 textbook — and give other schools of thought equal time.”
I don’t think heterodox economists and analysts like myself want to “dethrone the whole thing”. I think we simply point out that there are substantial flaws in the way modern macroeconomics is taught and practiced. Mainstream macro doesn’t need to be thrown out the window. But it does need to update its views to reflect the world we actually live in as opposed to these ridiculous “models” that even economists admit are poor reflections of reality.
He then claims the heterodoxy had the story wrong all along and that the mainstreamers had it all right:
“It is true that economists failed to predict the 2008 crisis (and so did almost everyone). But this wasn’t because economics lacked the tools to understand such things — we’ve long had a pretty good understanding of the logic of banking crises. What happened instead was a failure of real-world observation — failure to notice the rising importance of shadow banking. Economists looked at conventional banks, saw that they were protected by deposit insurance, and failed to realize that more than half the de facto banking system didn’t look like that anymore. This was a case of myopia — but it wasn’t a deep conceptual failure. And as soon as people did recognize the importance of shadow banking, the whole thing instantly fell into place: we were looking at a classic financial crisis.”
This is wildly misleading. The main thrust of the heterodox “story” over the last 5 years is that mainstream economists misunderstood clear operational realities of the monetary system and in doing so, they failed to understand both the crisis as well as the fixes. Take, for instance, Paul Krugman’s own positions in recent years:
- As late as 2011 Dr. Krugman didn’t understand why Japanese bond yields were low relative to Italian bond yields despite the massive debt loads in each nation. Some heterodox economists, like Warren Mosler, Wynne Godley and myself had been pointing out for years beforehand that there was a distinct operational difference between a country which issues its own currency in a truly autonomous currency area versus a nation like Italy which has effectively rendered itself a currency user. This was a MASSIVELY important understanding that has contributed to substantially flawed policy, politics and understandings.
- Or how about 2012 when Dr. Krugman said: “First of all, any individual bank does, in fact, have to lend out the money it receives in deposits. Bank loan officers can’t just issue checks out of thin air”. This is another obvious misunderstanding about basic banking and the money multipler (which has since been soundly resolved by the Bank of England). And he wasn’t alone. This misunderstanding ran the gamut of mainstream economists.
So mainstream economists misunderstood basic banking as well as basic operational realities like monetary sovereignty. These aren’t small mistakes. They are colossal misunderstandings. And I haven’t even begun to delve into the actual errors which lead to these misunderstandings. Indeed, it is the underpinnings of Mainstream Macro which lead to these erroneous conclusions in the first place.
So none of this was about working with “the wrong story line”. We aren’t merely telling stories. We are saying explicitly, that it is the Mainstream who relies on “story lines”, “classroom gadgets” like the IS/LM model, DSGE, other models which don’t reflect reality, and base their thinking on a version of the world which looks nothing like the modern monetary system. Mainstream Economics has failed to reflect the world in which we actually live. That is why there’s a revolt against it. And it’s the failure of Mainstream Macro to conform with evolving ideas, that is leading to an increasing call for its dismissal. Some economists will go down on their ship. Others are clearly trying to evolve and embrace the views of the heterodoxy, which, for the record, have outperformed the views of all the Mainstreamers by a pretty substantial margin over the last 5 years.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.