What Went Wrong (Part I)

In 2008 Paul Krugman wrote this piece in the New York Times How Did Economist Get it So Wrong? asking how the vast majority of economists had missed the buildup to the 2007 financial meltdown - perhaps the greatest macroeconomic event since the Great Depression.  Krugman’s answer was that the prevailing economic models – particularly those favored by “freshwater” economists – assumed perfectly competitive markets and rational expectations – thus ruling out the possibility of both bubbles and sustained recessions driven by lack of aggregate demand.  His story is convincing so far as it goes but the situation is actually worse than he suggests.  There are two problems (1) deficiencies in the sorts of models that academic economists were working with (2) a wide gap between the models that economists work with, what they teach, and what is commonly discussed in the public sphere.  The first problem may be the more academically interesting issue but the second problem likely has had a more negative impact.  I am going to focus on the latter issue.

Say you were a relatively smart person, college educated, but you had never taken an economics course.  Following the 2007 financial meltdown and subsequent economic slowdown you wanted to better understand how the macro-economy functioned.  How would you go about doing so?   One method would be to turn on CNBC or Bloomberg TV and listen to what the talking heads are saying.  A second alternative would be to search around on the internet.  A third method would be to walk over to your local Barnes and Noble and find an appropriate book from the Economics section.  I actually did the latter and it shocked me.

First step back a minute.  There is a canonical program in economics that is taught at almost every university.  In order to be an economics major you need to take Introduction to Economics, Microeconomics, Macroeconomics, some sort of Math or Statistics course, and then some number of electives which focus on more specific topics (Public Finance, Finance, Money & Banking, Game Theory, Industrial Organization, Health Economics, International Trade, Advanced Micro, Advanced Macro, etc…).  Sometimes there is a single Introduction class and sometimes there is an Introduction to Micro and an Introduction to Macro.  But that is the general game plan.

The macroeconomics that is taught to most undergraduates is pretty standard.  Here is the table of contents from Gregory Mankiw’s bestselling Macroeconomics textbook.  Lest I be accused of biasing my choice toward a left winger – Mankiw was Chairman of the Council of Economic Advisors under President Bush and a primary advisor to Gov. Romney.  Interestingly his textbook is not that different from noted liberal Paul Krugman’s Macroeconomics text.  There are half a dozen different basic to intermediate macroeconomics texts currently in use for undergraduates including (1) Abel Bernanke Croushore (2) Robert Gordon (3) Blanchard & Johnson (4) Charles Jones  They all cover similar topics in fairly similar manners.

They start by defining basic economic aggregates (GDP, consumption, investment etc) and explain how they are computed.  They define what money is and the various monetary aggregates; M0, M1, M2.  They explain how price indices like CPI are created and what inflation / deflation is.  Then the modeling starts.  Long run output is explained using some variant of the Solow growth model.  Long run aggregate supply results from the Solow model with some adjustment for labor market frictions and matching.  Short run fluctuations are explained using an aggregate supply / aggregate demand (AS-AD) model.   Short run aggregate supply is motivated by some variant of a Phillips curve relationship.  Short run aggregate demand is derived from the intersection of IS-LM.  The intersection of aggregate supply and aggregate demand then generate the aggregate price level for the economy.  Alternately they may choose to use David Romer's IS-MP / AS-IA construction.  Most books spend some time explaining the components of the IS curve; consumption, investment, government spending.  If they employ an LM curve then that comes from a discussion of money demand.  If they use an MP curve then that is motivated by a Taylor rule.  Most books also include an open economy version of the model.  It is pretty standard.

So back to my story.  I walk into the local Barnes and Noble and find the Economics section.  They have 295 different books in this section spanning all sorts of topics within economics.  However there is not a single book (not one) which explains macroeconomics in the way that it is taught to undergraduates.  The closest books that I could find were Economics for Dummies and The Complete Idiots Guide to Economics.  But both seemed targeted at high schoolers.  Neither had a substantial discussion of aggregate demand and aggregate supply like it appears in undergraduate textbooks.  I repeat 295 books!  I am not saying that there were no good books on economics.  They had a few historical classics of economics such as  

•  An Inquiry into the Nature and Causes of the Wealth of Nation – Adam Smith 
•  The Communist Manifesto – Marx & Engels
• Capitalism, Socialism, and Democracy – Joseph Schumpeter
• The General Theory of Employment, Prices, & Money – John Maynard Keynes 
• Risk, Uncertainty and Profit – Frank Knight
• The Road to Serfdom - F.A. Hayek 
• A Monetary History of the United States, 1867-1960 – Friedman & Schwarz

While these books made significant contributions to the history of economic thought they are neither modern treatments, nor are they very accessible, and in some cases of questionable validity (Marx and Hayek).   

Barnes & Noble also carried a few recent books which covered cutting edge topics such as

• General Equilibrium Theories of Value – Yves Balasko
• Lectures on Behavioral Macroeconomics – Paul De Grauwe
• Yield Curve Modeling and Forecasting – Diebold & Rudebusch

but these books practically require a reader to already have a graduate degree in the field to make heads or tails of the material.

Finally Barnes & Noble also has a number of good books on history of the world economy including

• Lords of Finance - Liaquat Ahmed
• A Monetary History of the United States, 1867-1960 – Friedman & Schwarz
• Trade Policy Disaster: Lessons from the 1930s (Ohlin Lectures) – Douglas Irwin
•  A History of the Federal Reserve, Volume 1: 1913-1951 – Allen Meltzer
•  This Time Is Different: Eight Centuries of Financial Folly – Reinhart & Rogoff 
•  In FED We Trust: Ben Bernanke's War on the Great Panic – David Wessel

Out of the 295 titles maybe 100 would fall into the categories of classics or recent academic books or quality histories.  Then there were probably 200 or so books which focus on why (1) the government is bad and free markets are good (2) corporations are bad and the government needs to intervene more (3) bankers are evil (4) China is (or is not) taking over the world (5) economists have it all wrong.  But if you want a simple explanation of macroeconomics at the level that it is taught to undergraduates there is nothing.  There also were no macroeconomics texts at the level of an incoming graduate student - although perhaps that is asking too much.  (The one possible exception was  The Elusive Quest for Growth by William Easterly which does touch on the growth part of undergraduate macroeconomics.)

So assume for a minute that I found a copy of Mankiw’s Macroeconomics on the shelf – would that make me happy?  No that is not the point.  The point is that the version of macroeconomics which is taught to undergraduates (and graduate students) is not really used as a basis for any of the popular books on the topic.  It would be like going to the Medicine section and getting to choose from the latest issue of JAMA's Archives of Neurology or books debating whether leeching or bleeding is the best method to banish the bad humors.  Neither is really that helpful to a novice.

Let’s go back again to my original question.  Say you were a relatively smart person, college educated, but you had never taken an economics course.  Following the 2007 financial meltdown and subsequent economic slowdown you wanted to better understand how the macro-economy functioned.  How would you go about doing so?   Well other than going to Barnes and Noble one could turn on CNBC or Bloomberg TV and listen to what the talking heads are saying.   But have you ever heard them speaking about short run aggregate supply curves, or whether the Phillips curve relation should include lags of inflation or only expectations of future inflation?  No.  They report the new macroeconomic announcements and earnings numbers, how the financial markets are reacting to them, and periodically insert their own crappy editorial analysis like this.  Or how about the internet?  There is a lot of really bad economic analysis on the internet.  There is also some good analysis - but how does one separate the bad from the good?

If we assume that what is taught to undergraduates reflects to some degree the views of the professors then based on the texts used there is really not that much difference of opinion among professors.   Furthermore the University of Chicago Booth School of Business surveys noted economists on a variety of economic and public policy topics (see here).  What is most surprising is how much unanimity of opinion there is among them.  But somehow it is not getting into the public sphere.  Instead we get the economic equivalent of a choice between JAMA or leeching and bleeding.