There has been a lot discussion around the Internet about the failure of economics in the Great Recession. One of the criticisms is about the profession's failure to predict the financial crisis. Krugman provides his answers to that question. He pleads ignorance to the changes that were happening in the financial industry. The shadow banking system played a huge role in the financial collapse, but it really did exist in the shadows. Economists were unaware of its size and influence.
Economists should have known about the moral hazards that existed in the system. Moral hazard is one of the important concepts in the profession. Moral hazard existed everywhere in the system but Krugman did not discuss the role of moral hazard in the financial crisis. Mortgages were originated and sold to investment banks which packaged them into securities. The loan originators collected a fee and passed the bad loans to investments banks which sold the securities to unwary clients who depended upon the rating agencies to determine the risk. The rating agencies obliged the investment banks by putting a AAA rating on securities that did not even conform to the underwriting standards of the investment banks. Everyone was getting rich producing toxic assets, and few were punished for the harm that was done to everyone else. While this was happening bank regulators ignored the warning signals. Alan Greenspan declared that he was shocked that bankers failed to regulate their own behavior because he, and millions of Americans, believed that markets were self regulating. That belief is one of the cornerstones of the economics profession. Regulation is assumed to distort markets. In an ideal world markets, left to their own devices, would produce ideal outcomes. Unfortunately, we do not live in an ideal world. We live in a world in which most of the participants are influenced by an incentive system that encourages otherwise honest people to do terrible things.
Krugman is less concerned about the failure of the failure of the economics profession to predict the financial crisis than he is about its failure to deal properly with the recession. He argues that recessions are due to a lack of demand and that governments should run budget deficits to compensate for the decline in demand by consumers and businesses. That is especially true when the central bank has reached the zero lower bound and cannot reduce interest rates any further. He cannot understand why the profession failed to use the knowledge that it has at its disposal. His favorite model of the economy told him exactly what should have been done.
Krugman's model of the economy is a Keynesian model which assumes that recessions are due to a lack of demand. Keynes believed full employment should be the goal of a market economy, but that the economy could reach an equilibrium below full employment. He did not believe that market forces were sufficient to end the Great Depression. He called for government to end the depression by running budget deficits. The economics profession has been engaged in a war against Keynesian concepts for the last 60 years. Many economists prefer a supply side explanation for recessions. They believe that the economy tends toward equilibrium at full employment and that government policies tend to reduce business confidence. If government would get out of the way, confidence would be restored and the economy would grow its way out of recession. Given this split within the economics profession, it is not surprising at all that the profession would not agree upon the best way to end the recession.
Krugman understands this split within the profession, but he cannot understand why the supply side economists did not change their minds about what should be done when their predictions about inflation and rising interest rates in response to government stimulus turned out to be wrong. He offers some explanations, but they only demonstrate that the economics profession does not share a common theory of the business cycle. Political ideology and economic ideology are necessarily intertwined.
At a deeper level one can also ask whether there is agreement within the profession that full employment is the appropriate mission for the economy. Business profits in the US have been at an all time high during the last few years of the recession. High unemployment keeps wages low and that might be part of the reason for historically high profits. The stock market reflects the high rate of profits, and shareholders have done very well despite the high rate of unemployment. Perhaps profit maximization is the real goal of the economy.