Paul Krugman's Speech In Lisbon On The Failures Of The Economics Profession In Great Recession

Paul Krugman's speech in Lisbon provides his analysis of the economics profession failures to deal with the Great Recession. He does a great job in pulling it all together. He does not believe that the profession is guilty of not predicting the GR. He does find it guilty of not understanding the growing role of the shadow banking system and the excessive use of leverage, and the dangers that they created which led to the financial crisis.

He also argues that practical and wise business people, and many experienced investors, have an intuitive understanding of how the economy normally operates which is adequate for normal business cycles. We don't need economists in normal periods. They were needed in the GR and the profession let us down. The DSGE models that are widely used in macroeconomics were not as useful as the older IS-LM models which did a better job of predicting what would happen, and in explaining why fiscal policy was even more important when the private sector was deleveraging. The DSGE models are essentially based on the failed real business cycle model with the addition of sticky prices and sticky wages.

There is normal tendency of politicians, who spend lots of time with practical business people, to look to them in a crisis. That was a big mistake. Their experience is less useful in abnormal periods. They encouraged politicians to make the mistaken analogy between how families respond to a fall in revenues and what government should do. The GR was not the time for government to tighten its belt. The GR is essentially a problem of depressed aggregate demand, and restoring business confidence is not the solution for increasing aggregate demand. Businesses respond to demand. They invest when spending is high and they hold back on spending in periods of weak demand. Economist's familiar with the IS-LM model were better prepared to provide advise to government.

Krugman is also critical of the role played by "fresh water economists", particularly those from the University of Chicago who revived Say's Law, which had been disproven long ago, to argue that government stimulus spending could have no impact on the GR. They provided lots of help to politicians who shared their view that government intervention in the economy only made things worse. The GR led to lower tax revenues and increased federal spending on transfer payments. Fresh Water economists aligned with politicians who used the resulting budget deficits to attack spending on social programs that conservatives have never liked. They put the focus on deficit reduction when we should have been paying more attention to aggregate demand and high unemployment.