Rocked by recession: A department's dilemma

In September 2009, Krugman used his position to lambast economists for their role in the financial crisis in a New York Times Magazine essay, “How Did Economists Get It So Wrong?” Unsurprisingly, he incurred the wrath of many fellow economists. University of Chicago economist John Cochrane, whom Krugman criticized in his article, responded with an article of his own, titled “How Did Paul Krugman Get It So Wrong?”

Yet for most professors in Princeton’s economics department, the lessons of the economic crisis are not about right versus wrong.

Members of the department, consistently ranked among the top few in the world, agree that the leadup to the financial crisis, and the recession that followed, have revealed flaws in their field’s approach.

Some of economists’ core assumptions — that people act rationally and that market prices reveal true value — did not hold during this tumultuous era. But rather than disavow their techniques, which rely on the use of such assumptions to understand complicated issues, members of the department have maintained faith in their approach, albeit with a larger dose of caution.

“If economic reasoning was so useless, then other fields would have jumped in to give greater insight,” said Markus Brunnermeier, a finance professor in the department, before switching to his native language of economics: “If economic reasoning was so useless, then we would be crowded out.”

Simon Potter, a visiting professor in macroeconomics who directs economic research at the New York Federal Reserve Bank, said that “[Krugman] spent a lot of time focused on the failures of macroeconomics and I think he oversold a bit.”

The bulk of Krugman’s criticism is directed at so-called “freshwater” economists — many of whom teach at the University of Chicago — who maintain that markets are completely efficient and rational.

In an interview with The Daily Princetonian, Krugman clarified that he believes “macroeconomists did not cause the recession,” instead placing the weight of the blame on “finance theorists,” who had convinced everyone that markets are trustworthy.

“Macroeconomics had lost touch with its Great Depression roots,” Krugman added.

Beth Bogan, a professor in the department who teaches introductory macroeconomics, as well as courses on economic policy and history, agreed with Krugman that understanding the Great Depression is fundamental to their field, calling the era the “defining moment in macroeconomics.”

In the opening days of that economic downturn, the federal government raised taxes and allowed the money supply to collapse, causing a Wall Street crash to escalate into the Great Depression.

Bogan said the reason that the current recession did not escalate to another Great Depression despite “similar precipitating factors” was the government response of keeping interest rates low to encourage bank lending and providing government stimulus, policies orchestrated as a testament to the lessons learned by macroeconomists.

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But on other points, economists are less proud of their field’s approach.

Much of economic research focuses on the study of specific phenomena — such as tax rebates or bank runs — to shed light on the broader economy. When economists choose a research topic, they make assumptions to simplify other market variables. Then they create models that track these phenomena in the past, allowing them to better predict future outcomes.

But overconfidence in the assumptions in their models led some economists to misread the buildup to the recession.

One assumption underlying most economic models, which has appeared increasingly problematic in light of the recession, is the idea that people are rational and will only make transactions that are in their best interests.

Alan Blinder ’67, a macroeconomics professor at the University who served as vice chairman of the Federal Reserve under President Bill Clinton, explained that this notion, called rational choice theory, holds when deviations from rationality are small and random, because any irrational actions would balance each other out.

This assumption is used in nearly every model. “It is not useful to say people are not rational,” Blinder explained, because one model cannot easily incorporate diverse forms of irrationality. “Tell me how to use that in designing the tax system.”

But during the real estate bubble leading up to the current recession, enough people acted irrationally to throw the models off.

People looking to buy houses could secure subprime mortgages that often coupled no down payment with low introductory payments. Lenders offered these mortgages to virtually anyone and shrouded details of escalating monthly payments in fine print. When homeowners finally realized that they could not afford their agreements, they defaulted en masse.

At the same time, the real estate market filled with hordes of investors who sought to take advantage of soaring housing prices by purchasing houses and selling them for a quick profit.

Prices rose further as more purchasers entered the market, and investors erroneously assumed that housing prices would rise indefinitely. “Rationality doesn’t take into consideration the herd-like instinct of people,” Bogan explained.

At the same time, another assumption of economists’ models began to waver: the efficient market hypothesis, which holds that markets provide accurate prices for goods by combining the collective preferences of millions of people.

But due to lending practices and speculation, home prices were rising on paper beyond their true value.

“The ship of the efficient market hypothesis has taken a torpedo in the hull and is sinking,” Blinder said. “I find it hard to square recent events with the efficient market hypothesis.”

Another practice challenged by the current recession is the division that had emerged between two branches of the field: finance economists, who study individual firms and banking methods, and macroeconomists, who examine interactions between broad economic sectors like consumers and government.

Banking methods gone wrong proved grave enough to put a dent in the broader economy, eventually requiring macroeconomists to consider finance in their analyses.

The lenders who sold subprime mortgages did not wait for repayment from homebuyers. Instead, they bundled mortgages together, spliced the bundles apart and sold chunks of mortgage debt to Wall Street banks and other investors. When people began defaulting on their mortgages, banks holding the bundles were not sure how much their investments — or those of other banks — were actually worth. They decided to drastically cut back lending, fearing that they would not be repaid.

In doing so, banks brought the wider economy to the verge of total collapse, as businesses struggled to finance day-to-day operations.

Economists have also realized that they had paid too little attention to the financial sector when looking at the government response to the lending crisis.

Macroeconomics holds that government can encourage lending by lowering the Federal Reserve’s target interest rate. Yet even after the Fed lowered rates to near zero in 2008, banks refused to resume lending, surprising macroeconomists.

Blinder said that the confluence of events causing the economic crisis presented a “freak show” scenario that that he would never have imagined before 2008.

Ultimately, the Fed increased lending between banks by purchasing billions of dollars of mortgages at high risk of default.

“There was a certain arrogance in macroeconomics,” Potter said of macroeconomists’ perspective on finance. The 2008 edition of the textbook he used for his intermediate macroeconomic course, which was written before the economic crisis, stated that the field has succeeded in reducing economic fluctuations and that the financial system was not an important source of fluctuations.

Since monetary policy in the form of interest rate changes proved to be ineffective in the recent economic crisis, faculty members are now moving to teach more about the financial system in their macroeconomics classes.

Blinder, who co-authored an introductory macroeconomic textbook with former department colleague William Baumol, has been preparing a new edition that includes more information on the role of financial markets in the economy, specifically discussing complex financial instruments like mortgage bundles.

In the fall of 2008, Bogan — who had been teaching introductory macroeconomics for decades — also decided to more heavily incorporate finance into her lessons.

Similarly, Brunnermeier said that finance economists need to be more aware of the intersection between finance and the broader economy.

Brunnermeier said he hopes that Princeton can be a leader in bringing these branches together. “The great thing about Princeton is that finance is not in the business school or in a separate department — it’s in the same economics department,” he said. “They can both enrich each other.”

Though macroeconomists have made some changes to their teaching and acknowledge the shortcomings of their assumptions, they still contend that such assumptions are necessary for research.

Potter said that while simplified economic models proved insufficient to capture an economic crisis, models “work really well in normal times.”

He added that in his job at the New York Federal Reserve, he uses models everyday to isolate issues for analysis.

Bogan, meanwhile, said that the assumption of rationality is still valuable, since most people tend to behave rationally.

“I worry a little bit about people outside of economics who say, ‘Well, man’s not rational and your whole model stinks,’ ” she said. “That’s nonsense.”

This is the first of two articles on how the Economics department has changed with the recession. Tomorrow: A look at economists’ evolving views on their role as academics.