Golden Oldies : Economics is basically about incentives and interaction — or, as Schelling put it, micromotives and macrobehavior. You try to think about what people will do in certain circumstances, and you try to understand how individual behavior adds up to an overall result. What economists have known since Bagehot (with regard to financial markets) and since Keynes (with regard to goods and labor markets) is that under some circumstances seemingly reasonable individual behavior adds up to very unreasonable macro outcomes. Bagehot wrote of panics in which the collective desire to shed risky assets and debt produced a downward spiral; Keynes of situations in which the collective desire to save but not invest led to mass unemployment. And in both cases these arguments suggested a case for government intervention to undo or limit the bad macro consequences of reasonable individual behavior.
But notice that I’ve framed this in terms of “reasonable” behavior; it’s a lot harder to tell these stories in terms of perfectly rational, maximizing behavior. One response — a pretty good response — is, “So?” After all, maximization isn’t a fact about human behavior, it’s a gadget — an assumption we use to cut through the complexities of psychology... useful if it clarifies your thought, but by no means an axiom or a law of nature....
[A]pplying maximizing thinking has achieved some major successes even in macroeconomics. The permanent income/life cycle style of consumption theory does a much better job of accounting for the stylized facts about spending than the old, mechanical consumption function. The natural rate hypothesis... was the result of (loose) maximizing reasoning.
But from the 1970s onwards... the drive to base everything on maximizing behavior narrowed the profession’s thinking... led... to a total forgetting of the great insights about interaction. We created an economics profession which believed that Keynesian economics, and for that matter Bagehotian finance, had been “proved wrong”; whereas all that had really happened was that those things proved hard to model in terms of perfectly rational maximizing agents. Again, so?
And there’s a sense in which even New Keynesian economics was wasted effort, at least from a social point of view, because it was mainly a way of showing New Classical types that we can too ground the concepts we already knew in maximizing models. Actually, I don’t think that’s entirely fair: I find that New Keynesian models, especially on the liquidity trap issue, do deepen my understanding. Still, you can understand why Larry Summers says that none of that stuff proved useful in actual policymaking.
The point, though, is that something went terribly wrong. Put it this way: if all we had known when this crisis struck was 1950-vintage macroeconomics, we would probably have done a better job of responding.
At Bretton Woods, Summers interviewed by Martin Wolf:
Martin Wolf: How far do you feel that what we have experienced in the last few years suggests that economists just did not understand what was going on?
Larry Summers: There are things economists did not know. There are things economists were wrong about. And there are things where some economists were right.
When I was in the government, I got a lot of papers in the mail. To the first approximation, I attempted to read all of the ones that used the words "leverage," "liquidity," "deflation," or "depression." I attempted to read none of the ones that used the words "neoclassical," "choice-theoretic," "real business cycle," or "optimizing model of..." There were more in the second category than there were in the first. But there were a reasonable number in the first. And they told you a lot.
There is a lot in [Walter] Bagehot['s 1873 Lombard Street] about the crisis we just went through. There is more in Minsky. And there is still more in [Charles] Kindlberger['s 1978 Manias, Panics, and Crashes.] There are enormous amounts that are essentially distracting, confusing, and problem-denying in the stuff that is the substance of the first year course in Ph.D. programs. I think economics knows a fair amount. I think economics has forgotten a fair amount that is relevant. And it has been distracted by an enormous amount.
I do not think that in general macroeconomics kept up with the revolution in finance, as it was realized that asset prices show large volatility that does not reflect anything about fundamentals. I do not think contemporary macroeconomics adjusted or adapted to changes in the patterns of financial intermediation, and the ways in which that took place. I think people who were practical understood concepts of liquidity finding its way into price inflation or asset price inflation and being problematic either way, but those concepts were at the very edge--or in many cases not even at the very edge--of contemporary macroeconomics, to the great detriment of contemporary macroeconomics.
On the other hand, it is common at a moment like this to go into a general bash on economics. Everyone who hates economics because they do not like markets in any context, or because they don't do math and if you don't do subjects that use math you have a bias toward believing that math is useless, has piled on at this moment to take this crisis as a repudiation of economics. But I do not think that is right. I think the wisdom that is in the Bagehot-Minsky-Kindleberger-Eichengreen-Akerlof-Shiller and many many others actually runs way ahead of those who bring negative attitudes to economics. And I think we make a serious mistake when we throw the baby out with the bathwater....
Wolf: You came very close to saying that modern economics as taught in graduate schools along with a great part of the research work that goes along with it was, as it were, an organized and systematic system--I am not saying a conspiracy--for forgetting what economists actually knew. Is that what you are saying?
Summers: It would be interesting to look at surveys. I was heavily influenced, as I did whatever it was I did, by the basic Keynesian IS-LM framework, as augmented to take account of the liquidity trap. I was heavily influenced by a variety of writings of Jim Tobin about financial intermediation, particularly about debt-deflation and the prospect of instability. I was substantially influenced by work on bank runs, multiple equilibria, that is more recent. I was influenced by a good deal of what modern finance understands about bankruptcy and restructuring, as we thought about treating the banks and the automobile companies.
I would have to say that the vast edifice in both its new Keynesian variety and its new classical variety of attempting to place microfoundations under macroeconomics was not something that informed the policy-making process in any important way.
Now to be fair, I have heard it said that if you actually wanted to know where a planet was the Ptolemaic astronomical system did better than the Copernican astronomical system for fifty years after the world moved to Copernicus. So a variety of that research may find its day and may find its moment. But it was not a moment that had an enormous influence in this crisis. It is my impression that it would be quite easy to graduate with a Ph.D. in economics from many prominent economics departments in this country with only the vaguest notion of what the liquidity trap is, while at the same time being familiar with a substantial amount of subtlety surrounding dynamic stochastic general equilibrium. And that latter subtlety did not inform our policymaking process,. Having read the policymaking prescriptions of those attached to dynamic stochastic general equilibrium, I am not led to think that the world would be in a better place had their laissez-faire style recommendations been pursued.