Saturday, December 4, 2010

Krugman on Old Economic Ideas That Refuse to Die

I think that Krugman is correct in raising the question on why economic theories survive the brutal facts that demonstrate their irrelevance to the real world. Many books have been written on this topic since the financial crisis exposed the problems with prevailing theory. I suggest at least two answers. The first is that academics is not always about the real world. We reward smart people who can develop models that are logically consistent. Most real world economic problems can only be made logically consistent, and amenable to mathematics, by the use of simplifying assumptions that often distort reality and the application of the models to real economic problems. The second answer is that many of the dominant theories are reactionary. That is, they are in response to other approaches to economics, for example Keynesian theory, which advocated a powerful role for an enlightened government in a mixed economy. I'd bet that many on Wall Street still believe in a very limited role for government in the economy despite the fact that without government intervention the entire system would have collapsed.

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