How Did Economists Get it so Wrong?

By Paul Krugman  

http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?_r=1

 A. What indicators made the economic “profession” believe that they had resolved their theoretical internal disputes?  The differences in theory did not just go away; they were obviously either disregarded or suppressed.  Why would highly educated people not recognize this?

Basically, the theories of macroeconomics have two main areas of study: the causes and consequences of the short term national income fluctuations; and the factors that determine long term economic growth.  From the surface, both the areas seemed strong hence flawless for the “profession” to believe that they had resolved their theoretical disputes. Many of the economist since the past 30 years or so abide by the rule that economic cycles are driven by the producers and consumers of goods and services in the ‘real economy’, They neglected the important roles that banks and other financial institutions play in the economy and rejected anything that did not fit their mathematical models.

 B. What does “schlock economics” mean?

“Schlock economics” literally would mean meaningless economics. Robert Lucas, a specialist in macroeconomics and government policy remarks that the promise of large multipliers presented by private macroeconomic consulting firms in support of the stimulus bill was "schlock economics."

 C. The author states that “any attempt to fight an economic slump would do more harm than good”.  Isn’t this what is happening right now with all of the bailouts?  Won’t we see repercussions of current government actions for years?   

 To answer the question: To fight the economic slump, the stimulus bill was promoted under view that only the federal government can help the country’s financial state. For instance, many argue that the stimulus bill is based on outdated Keynesian economics and therefore, the 1930s Keynesian model is not useful in meeting today's standards for economic analysis.

          It is said that “economics is about incentives: the incentives for households to work, consume and save, and the incentives for business to hire workers and invest in plants and equipment. And modern economic analysis shows that the impact of government spending on the economy depends on what it is being spent on and how it ultimately is paid for.”

          Thus, the bill can be negative, depending on how the spending is ultimately financed. Certainly, we will witness the repercussions of current government actions for years. The stimulus recovery act will leave us with a legacy of substantially rising debt without a commensurate benefit. The CBO notes that federal debt, which was about 40% of GDP at the end of 2008, is expected to rise to more than 80% of GDP in 10 years. And with no change in policy, debt could rise to nearly 100% of GDP before then. Add in the burden of unfunded government liabilities, including social security and government pensions, and the debt burden becomes truly staggering--one of the biggest economic challenges facing the U.S.  Our current crisis may soon be over, but we are in the process of creating a debt crisis of substantial proportion, and one that is not cyclical but rather is permanent. A sensible resolution of this debt crisis fundamentally requires reducing federal spending.

D. Why have we retreated from Keynesianism and returned to neoclassicism?  What are real life changes in the market that would indicate this? 

We retreated from Keynesianism and returned to neoclassicism: Keynes claimed that prices were not flexible downward and that in response to reductions in consumer demand, we can expect reductions in output rather than reductions in prices. However, the market, even Wal-Mart is lowering their prices in response to sluggish demand. It is an approach to economics that relates supply and demand to an individual's rationality and his ability to maximize utility or profit. Neoclassical economics also increases the use of mathematical equations in the study of various aspects of the economy. 

E. Why is investor irrationality described as “bubbles”?

       And why are bubbles called “bubbles” in the first place: I am guessing that because asset prices often deviate strongly from intrinsic values and are mostly traded in inflated price, it has been termed as bubble.