Krugman on Keynes – how economists screwed up

Comments (5)

1. It was interesting to read. Not least because he confirmed a sentiment I’d had since I first started hearing economists speak. Namely, the field (particularly what he called the freshwater school, and I’m from freshwater area) had divorced itself from observation. Bad things could not happen, by definition. Therefore if you pointed to a bad thing, you were simply wrong for thinking it was bad.

   He’s more measured, and more interesting, than that. The history alone is a good read.

   Still, it strikes me that what happened in economics, and economic modelling, can be analogized in weather modelling. What they did over the past 35 years is akin to weather modellers declaring that there are no such things as hurricanes. Therefore they don’t exist. And, if you point to one, they say that it isn’t a hurricane.

2. I had two immediate thoughts while reading Krugman’s essay. (Biographical note: I’ve traded plain vanilla derivatives for hedge funds for nearly 20 years using evolutionary models.) One was a flashback to what one of the partners at Long-Term Capital Management, an MIT engineering graduate, said: “We used to go over to the physics library to find formulas to jam into finance.”

   The second was purely egocentric. In an article published in the British magazine Risk one month before LTCM famously collapsed in August 1998, blowing through nearly $4 billion in capital in single digit weeks, I wrote

   The array of powerful statistical techniques available to the risk manager… are founded on quicksand.

   And so it proved. But I sure took a lot of heat from finance professionals and traders for that article and another called Finance is not physics.

3. The try anything in a crisis is interesting, would it include doing nothing and let the market decide?

   Goverments never seem able not to stick their grubby mitts in, oftem making things worse.

4. When I was in college, I had to take finance and economics courses as part of my major. They all sounded good. In fact, they sounded so good I considered both as minors or going into a double-major with one of them.

   Except one problem, my “hobby” in life is abnormal/behavioral psychology. Because of this, I know people aren’t rational. Never mind that it’s obvious people aren’t rational if you JUST PAY ATTENTION, too many well designed studies have shown up, time-and-time again that people do not behave in a rational manner when it comes to financial and economic decisions.

   So as I’m sitting there in my economics and finance classes I come to the realization: they’re full of shit. No kind way to put it. These guys are living in a fantasy land where each consumer is a robot or computer and is going to make optimized, rational decisions…

   So, thirty-years later… I’m laughing. I managed to escape the idiotic training I’ve been given. Plus my observations to the state of much of finance and economic theory have been vindicated.

   Unlike my friends who are all suffering various crisis’s because they bought into the fairy tales…

5. Donald MacKenzie’s “An Engine Not a Camera” on options trading and finance models is a must read. His spotlighting of the role of arbitrage in rational agent models is important for understand those models. Krugman discusses this, if you know to look for it (particularly the nice point about market irrationality outlasting the capital of arbitrageurs, but Larry Summers’ “ketchup economics” insult is also prominent). I am sympathetic to axiomatic modeling as an academic practice, but we need a better socio-philosophical and historical understanding of its relationship to policy in order to understand precisely what goes wrong where. The relevant debates go back to Weber and “ideal types”, and really much further. Endlessly fascinating, and a huge opportunity for new work…

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