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This article is perfect – it explains it so well –

from New York Times – 09 – 02 – 09

How Did Economists Get It So Wrong?

Published: September 2, 2009

To be fair, finance theorists didn’t accept the efficient-market hypothesis merely because it was elegant, convenient and lucrative. They also produced a great deal of statistical evidence, which at first seemed strongly supportive. But this evidence was of an oddly limited form.

Finance economists rarely asked the seemingly obvious (though not easily answered) question of whether asset prices made sense given real-world fundamentals like earnings. Instead, they asked only whether asset prices made sense given other asset prices.

Larry Summers, now the top economic adviser in the Obama administration, once mocked finance professors with a parable about “ketchup economists” who “have shown that two-quart bottles of ketchup invariably sell for exactly twice as much as one-quart bottles of ketchup,” and conclude from this that the ketchup market is perfectly efficient.

But neither this mockery nor more polite critiques from economists like Robert Shiller of Yale had much effect. Finance theorists continued to believe that their models were essentially right, and so did many people making real-world decisions.

Not least among these was Alan Greenspan, who was then the Fed chairman and a long-time supporter of financial deregulation whose rejection of calls to rein in subprime lending or address the ever-inflating housing bubble rested in large part on the belief that modern financial economics had everything under control.

There was a telling moment in 2005, at a conference held to honor Greenspan’s tenure at the Fed. One brave attendee, Raghuram Rajan (of the University of Chicago, surprisingly), presented a paper warning that the financial system was taking on potentially dangerous levels of risk. He was mocked by almost all present — including, by the way, Larry Summers, who dismissed his warnings as “misguided.”

By October of last year, however, Greenspan was admitting that he was in a state of “shocked disbelief,” because “the whole intellectual edifice” had “collapsed.”

Since this collapse of the intellectual edifice was also a collapse of real-world markets, the result was a severe recession — the worst, by many measures, since the Great Depression. What should policy makers do?

Unfortunately, macroeconomics, which should have been providing clear guidance about how to address the slumping economy, was in its own state of disarray.

[Etc. – it is worth reading the whole thing – all 8 pages]

[excerpted from – ]

http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?pagewanted=3&em

http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?pagewanted=1&em

Paul Krugman is a Times Op-Ed columnist and winner of the 2008 Nobel Memorial Prize in Economic Science. His latest book is “The Return of Depression Economics and the Crisis of 2008.”

New York Times

How Did Economists Get It So Wrong?

By PAUL KRUGMAN
Published: September 2, 2009

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