Krugman’s Simplified History

by on September 14, 2009 at 7:10 am in Economics | Permalink

One of the themes of Paul Krugman’s theya culpa is that the economics profession was so entranced by efficient markets theory that “Discussion of investor irrationality, of bubbles, of destructive speculation had virtually disappeared from academic discourse.” Alan Greenspan comes in for particular criticism:

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..[and]… a general belief that bubbles just don’t happen.

It’s a good story–not the least because there is some truth to it–but there are also many omissions which cast doubt on the thesis.  Hardly anyone wants to recall today, for example, that it was Alan Greenspan who popularized the term “irrational exuberance,” in a speech in December of 1996.  At the time, Greenspan’s remarks were covered around the world and they created a sell off in stocks.  In a NYTimes article titled Irrational Exuberance, Louis Uchitelle wrote:

That sort of optimism cannot last; stocks that are too highly priced will inevitably fall, perhaps over a long period, as they did in the mid-1970’s. Mr. Greenspan, who is 71, lived through that painful downturn as a top economic adviser in the Ford Administration.

This time, a falling stock market might have a broader impact. Many more Americans own stocks today than in the past, and a downturn could cut deeply into their sense of well-being. The result could be a severe cutback in spending, hurting the economy. For that reason, the stock market has become increasingly important in the deliberations of the Federal Reserve over interest rates — whether to raise them to slow the economy or lower them to encourage spending and growth.

Greenspan in Uchitelle’s piece is the one raising questions about market prices.  Furthermore, no economist in Uchitelle’s piece says that prices are always correct or that markets are perfectly efficient or that bubbles are impossible–the mainstream view according to Krugman.  Robert Shiller is quoted not Eugene Fama.  And, of course, it was Robert Shiller who would later author two bestsellers warning of bubbles, another discomforting fact for those who argue that dissenting economists were marginalized.

The point is not to defend Greenspan.  Indeed, in some sense Greenspan was as wrong about stocks in 1996 as he was about housing in 2004 but the errors were of opposite signs–this in itself is a telling point and a key element of a more nuanced story about how economists got things wrong and the difficulties of getting things right.

The point is that if we are to understand recent history it’s neither true nor useful to argue that Greenspan and other economists thought the price was always right.

1 Mario Rizzo September 14, 2009 at 7:52 am

I am wondering whether Krugman is confusing two ideas: (1) Prices are always “right” and (2) It is difficult/impossible to tell just when and how they are wrong — that is, you can’t say when a bubble is occuring.

2 Pavel Kohout September 14, 2009 at 8:10 am

The intellectual arrogance of hard-core adherents to EMH has been striking. Even now some of them claim that the stock market is efficient. Numerous arguments against market efficiency are flatly refused by using all kinds of logical errors and manipulative techniques you can imagine.

“Market agents may use wrong models of the market, but still it doesn’t mean that the market isn’t information-efficient” – thus, the stock index may be mispriced by tens or even hundreds of percent, but still, the market is EFFICIENT.

My favorite example is a quasi-argument by a business lawyer: “If you admit the EMH is wrong, it might have serious impact on the stability of financial contracts and it may affect many businesses!” Argumentum ad baculum at work.

3 Pavel Kohout September 14, 2009 at 8:12 am

Oh yes. The EMH crowd often cries “you’re insane, you’re completely insane!” when out of all other arguments.

4 Andrew September 14, 2009 at 8:29 am

See, it has to be Alan’s fault, because if it’s not, then the scores of liberals and bureaucrats share the blame, and of course Alan was not only a Republican but a libertarian, so double bonus.

The markets are usually about right. If Krugman is in effect saying, “all those horse players are idiots” then why is he living on an economists pittance? Again, the only people I consistently saw criticizing the Empire of Debt were libertarians. Selection bias to be sure, but very few exceptions.

5 Nik Kondratieff September 14, 2009 at 9:01 am


the question isn’t whether Greenspan (or any other economist) is right or wrong, it’s whether he thinks he’s always right and what impact that has on the lay politicians who buy his theories? Unfortunately, your profession is predicated on fiction and, as a result, provides insight useful only to those who live in a fantasyland.

If you want to create economic policies that prevent a repeat of previous crises and market crashes, you need to study historians like Niall Ferguson, Richard Sylla, Peter Temin, and other historians who have a much better understanding of the world than some silly reductionist arguments pretending to be a science.


6 Sergey Kurdakov September 14, 2009 at 9:11 am

The problem at hand – than NO ‘simple’ equation could describe the behavior of the markets. It is known not due to some assumptions ‘efficient market hypothesis’ but due to Ashby’s Law of Requisite Variety ( from cybernetics ) – the ‘diversity’ of the economic system is much more than can be described in simplified manner. So when economic system starts to change ( due to some internal shocks or developed tendencies) – no one could spot them from equations as those were build in essentially reduced assumptions and on reduced variety.

One could spot changes only by constant observing of entire possible states.
and that should include behavior of many actors ( people, institutions etc ).

That is why the idea to have a agent based model of entire world might be useful. Of cause – initially it will be absolutely useless. But feeding real time data and adjusting it – it ( possibly in only in exhibits essential numerical instability ( but still the real world is stable to some degree ), it could be possible to sense entire variety – not using one or two equations – but an assemble of models which are adjusted in quite a long time of real observations.

7 Mario Sanchez September 14, 2009 at 9:38 am

Reading Mr Greenspan’s most famous statement should convince any thinking human that (at least at one point) he did not believe that markets are perfect & rational or that financiers or central bankers had perfect models. From

“I wish I could say that there is a bound volume of immutable instructions on my desk on how effectively to implement policy to achieve our goals of maximum employment, sustainable economic growth, and price stability. Instead, we have to deal with a dynamic, continuously evolving economy whose structure appears to change from business cycle to business cycle… This process is not easy to get right at all times, and it is often difficult to convey to the American people, whose support is essential to our mission….”

“There is, regrettably, no simple model of the American economy that can effectively explain the levels of output, employment, and inflation. In principle, there may be some unbelievably complex set of equations that does that. But we have not been able to find them, and do not believe anyone else has either….”

“At different times in our history a varying set of simple indicators seemed successfully to summarize the state of monetary policy and its relationship to the economy. Thus, during the decades of the 1970s and 1980s, trends in money supply, first M1, then M2, were useful guides…. Unfortunately, money supply trends veered off path several years ago as a useful summary of the overall economy…. There are some indications that the money demand relationships to interest rates and income may be coming back on track. It is too soon to tell, and in any event we can not in the future expect to rely a great deal on money supply in making monetary policy…”

“As the century draws to a close, the simple notion of price has turned decidedly ambiguous. What is the price of a unit of software or a legal opinion? How does one evaluate the price change of a cataract operation over a ten-year period when the nature of the procedure and its impact on the patient changes so radically. Indeed, how will we measure inflation, and the associated financial and real implications, in the twenty-first century when our data–using current techniques–could become increasingly less adequate to trace price trends over time?… Doubtless, we will develop new techniques of price measurement to unearth them as the years go on. It is crucial that we do, for inflation can destabilize an economy even if faulty price indexes fail to reveal it….”

“But where do we draw the line on what prices matter? Certainly prices of goods and services now being produced–our basic measure of inflation–matter. But what about futures prices or more importantly prices of claims on future goods and services, like equities, real estate, or other earning assets? Are stability of these prices essential to the stability of the economy?… How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy?… But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.”

8 Seward September 14, 2009 at 9:43 am

Markets are no more rational than government; they’re just better (for a number of different reasons) on average than governments.

Far more dangerous than any myth about rational markets is the romantic myths which go along with government and its supposed ability to engineer people and societies; new societies and new men as it were.

9 TGGP September 14, 2009 at 10:08 am

“agnostic” did a JSTOR search to compare how often terms denoting market failure popped up, compared to normal economics terms like “supply and demand”. The teaser is here, he expects people to pay for the whole thing.

10 eccdogg September 14, 2009 at 10:35 am

Stocks have no Platonic “Value”. So saying that stocks are undervalued or overvalued or that the market price is the best predictor of a stock’s future “Value” is just silly.

Assets are worth what people will pay for them and it is damn near impossible to predict how the amount people will pay for something will change. And thier is a good reason for this, there are millions of people who spend every moment of their working time trying to figure out how much an asset is worth “to them” and how the value it is worth to others might change. So prices reflect the best guess of people who put their money where thier mouth is.

The EMH hypothesis is best understood as “It is almost impossible to out guess the market on a regular basis” this I totally believe. To me the EMH does not say the prices in the market are the “RIGHT” price for assest as ordained by god, because no such value exist.

11 Andrew September 14, 2009 at 10:59 am

Come on folks. Sure, Greenspan did help de-regulate, or at least was the poster child for de-regulation, if you believe it. But are we to believe that Alan ran the univers from his secret Fed meetings and that the handwaiving gibberish he fed Congress was really code for all his minions?

And, now economists don’t want to know what this omnipotent Fed that can defy the army of regulators in government is doing? And who has been its harshest critic and is pushing to audit them now against the resistance of the economists? That’s right folks, Ron Paul, the libertarian Republican Congressman. Come on Dr. Krugman, you are better than that.

We are at 10% unemployment. While the very low unemployment of recent history is probably a contributing factor to the bust especially when households got overleveraged (though THEY weren’t complaining at the time), are we so sure that it wasn’t worth it? The market crashed, the lender of last resort did its job. The Fed swept up the mess after the party just as Greenspan suggested it should. The market was overvalued, dropped by 40% or so, probably 20% too much, then rebounded about 20%. That is how the market gets the price about right.

12 Thomas DeMeo September 14, 2009 at 11:07 am

This is a semantic argument. There is no such thing as a “right” price.

The big problem is with the ability of the markets to introduce changes which combines to greatly increase business cycle momentum. Derivatives, risk management and a dramatic increase in the speed of modern transactions make pricing infinitely more complex- too complex for markets to think through. Human beings can look at a car, test drive it, and then make a reasonable judgement about it’s price. However, anticipating the domino effects of a price change on derivatives is a different matter.

With no history of a complete business cycle with these factors, how could anyone know how much momentum was in the system?

13 John Thacker September 14, 2009 at 11:47 am

Greenspan may have said “irrational” but he didn’t do anything about it.

If he didn’t do anything about it, that makes him much better off than Fannie and Freddie and the housing regulators, who “did something about it” in encouraging it, and in jumping into the whole subprime market and thinking that everyone should buy a home even if they couldn’t afford it. Government doing nothing to encourage would have been better than what it did.

Since in “weak” EMH unpredictable == efficient, “weak” EMH is proven true every day (by tautology).

You misunderstand the technical definition of unpredictable. It doesn’t just mean that they move around; it means that you (and everyone else) can’t beat the market. (Though you can get higher returns by accepting more risk.) It means that systematic theories don’t work forever and will be arbitraged away. We have excellent experimental data for this.

The EMH itself predicted that this collapse would happen, just as it predicted that Long Term Capital Management would fail. If you believe that prices are inefficient, then arbitrage can work forever. If you think that prices are inefficient, then you can believe that Wall Street could figure out a perfect system to get higher returns without risk.

But if you believe the EMH, then have to believe that risk can’t be hedged away, that there’s no way to achieve returns without risk, that any model that predicts the past will become useless as soon as everyone starts using it to hedge. Understanding the EMH would tell you that you can’t hedge away risk just because two things have traditionally moved in opposite; your hedging destroys that relationship. It would tell you that there’s absolutely no way that “house prices always go up,” as if prices are right, that means that they can fall as easily as rise. The EMH says that if it were a sure bet that house prices would go up, they’d already do so, so there must be risk. It says that corrections inevitably come (but their timing can’t be predicted), and that increasing your leverage ensures that you’ll fall when they do.

Certainly stupid bankers mouthed the EMH but didn’t realize its implications– though the LTCM guys were arguably guilty of even more hubris, since they should have known.

It was believing in the EMH that told me that a crash was coming– not because I thought that the prices were “wrong” at that moment but because people kept increasing their leverage in search of returns and using the same mathematical models used by everyone else. It’s precisely because I thought that prices were “right” that I thought that prices could go down as easily as they go up, and that a correction would happen at some point, I just didn’t know when. Corrections always happen eventually, but people did their best to make it worse, because they didn’t really believe the EMH.

14 Sam Penrose September 14, 2009 at 12:00 pm

“a key element of a more nuanced story about how economists got things wrong and the difficulties of getting things right.”

Here’s Krugman in 2005:

Looks like he managed to get it right without much nuance at all.

15 Steven Donegal September 14, 2009 at 12:12 pm

“The point is that if we are to understand recent history it’s neither true nor useful to argue that Greenspan and other economists thought the price was always right.”

It seems the important lesson isn’t that economists thought the price was always right, but that economists had no idea whether the price was right. Unfortunately, this is not a lesson we will take to heart.

16 Joe September 14, 2009 at 12:49 pm


“Greenspan in Uchitelle’s piece is the one raising questions about market prices. Furthermore, no economist in Uchitelle’s piece says that prices are always correct or that markets are perfectly efficient or that bubbles are impossible–the mainstream view according to Krugman. Robert Shiller is quoted not Eugene Fama. And, of course, it was Robert Shiller who would later author two bestsellers warning of bubbles, another discomforting fact for those who argue that dissenting economists were marginalized.”

Come again? Shiller being quoted by the NY Times and writing bestselling books suggests he wasn’t marginalized by academic economists? Sloppy reasoning, given that, y’know, neither the media nor the American public are academic economists.

To the media, Ben Stein was a respectable economist who got far more exposure than Shiller -despite demonstrably not being an economist! Few in academic medicine take Andrew Weil or the anti-vaccine quacks seriously, even though they have both characteristics. How many certifiably nutty (or at least, fact-devoid) political pundits have bestselling books and TV appearances, let alone mere quotes in a newspaper?

We would also expect Shiller to sell books even if he were certifiably crazy according to economists – cognitive bias. If mainstream economics says that liberal policies are stupid, liberals won’t react by buying books about how stupid they are – they’ll buy books by non-mainstream economists telling them that mainstream economics is nuts. (This is the same principle underlying why I’ve never met an Austrian who wasn’t at least leaning libertarian first.)


Except in the rare cases where people deliberately buy stocks out of emotional attachments, stocks do have an intrinsic value – the present value of the future stream of dividends. People may disagree as to what this value is, but it does exist.

The “strong” (“price is right”) position says that the value of the stock will always reflect the best possible estimate of the PV. Thus, the “no free lunch” principle follows (you can never consistently beat the market because the market reflects the best possible estimate – beating the market is truly a luck event).

In that sense, stocks certainly can be overvalued or undervalued. Dick Thaler’s examples are good ones – mutual funds that trade at a different value than their underlying shares, the market valuing 3Com (other than its ownership of Palm) at a negative value (obviously, the value of a limited liability entity can’t go below zero).

You can decouple the “no free lunch” principle by making it into “the market is too random to consistently beat,” but that’s not what Krugman is arguing about.

17 PJ September 14, 2009 at 1:24 pm

It’s not just the EMH or rational expectations folk that Krugman slams. He also repeats his criticism of monetarists (Friedman especially) as narrowly focused on money growth even during recessions. Which is not true at all. I pity the NYT readers who rely on Krugman for lessons on economic theory.

It seems to me that the latest economic principals gives a fair appraisal of Krugman’s piece:

18 John Thacker September 14, 2009 at 2:06 pm

Economists who pretend to have a the true model of the economy, rather than just the best fitting, mathematically tractable model, are just arrogant and delusional.

Yes, this is what the EMH means. Anyone, economists or not, who pretend to have a true model of the economy or a “system” that can predict it, is arrogant and delusional. It seems like you agree with the EMH even as you claim to be disagreeing with it. The only academic who thinks that you can model the economy is Ray Fair, and he’s more a Keynesian. In general, all this mess about claiming that you know exactly how a stimulus is going to affect the economy is crude Keynesianism, but it’s quite the standard approach in the real policy-making world, even if not among academics.

Most of the problems of the bubble got caused by people disbelieving the EMH. If you believed the EMH, you’d never think “Owning is always better than renting.” If you believed the EMH, you’d never think “House prices always go up.” If you believed the EMH, you’d never think, “We’ve found a perfect way to hedge away risk, so we’ve increased our return with no risk.”

I-bankers and others who mouth the EMH do so because they believe that it justifies their large salaries both practically and morally. (“I’m making the markets work more efficiently, and I must be worth this since the market pays me.”) But they don’t really understand it or agree with it, as judged by their behavior.

Someone who really believes in the strong EMH dumps all their money into portfolios of index funds and lets someone else chase after the ephemera, believing that the costs (and risks) of getting those above-market returns will eat up those returns in the long run.

19 EorrFU September 14, 2009 at 2:22 pm

Krugman wasn’t trying to give a wide and accurate depiction of Economics, he was trying to explain the one battle in economics that has had the most overwhelming effects in policy decisions. The article is about governance and how economics can help describe how the world works so that policy makers can make more informed decisions. From the politicians point of view these are the only economists out there. Saltwater vs. Freshwater becomes a valid dichotomy of the economics profession BECAUSE that is how the policy debate happens.

20 eccdogg September 14, 2009 at 2:43 pm

Example of LTCM entering a convergence trade to exploit “irrationality”.

“A good illustration of the consequences of these forced liquidations is given by Lowenstein (2000).[15] He reports that LTCM established an arbitrage position in the dual-listed company (or “DLC”) Royal Dutch Shell in the summer of 1997, when Royal Dutch traded at an 8 to 10 percent premium relative to Shell. In total $2.3 billion was invested, half of which long in Shell and the other half short in Royal Dutch.[16] LTCM was essentially betting that the share prices of Royal Dutch and Shell would converge. This may have happened in the long run, but due to its losses on other positions, LTCM had to unwind its position in Royal Dutch Shell. Lowenstein reports that the premium of Royal Dutch had increased to about 22 percent, which implies that LTCM incurred a large loss on this arbitrage strategy. LTCM lost $286 million in equity pairs trading and more than half of this loss is accounted for by the Royal Dutch Shell trade.”

21 Andrew September 14, 2009 at 3:06 pm

Another thing to keep in mind is a distinction (to me) between libertarians and EMH academics. The libertarians believe people make the best decisions for their own lives. However, the EMHers extend this to financial products. However, there are a lot of additional reasons people would be irrational when dealing with financial instruments. Libertarians make kind of an exception for banking via the Austrian theories, to break off the rationality exactly where EMHers start with it. And it’s probably not a coincidence that the average people got in trouble as soon as they started treating their houses primarily as financial instruments.

22 Sam Penrose September 14, 2009 at 5:38 pm


Your point that Krugman wrote a lot of columns about a lot of topics during this period is fair enough. But I simply cannot square your comment:

“he doesn’t see that the housing bubble … did at the time and would in the future effect the real economy”

with the column’s conclusion:

“[T]hese days, Americans make a living selling each other houses, paid for with money borrowed from the Chinese. Somehow, that doesn’t seem like a sustainable lifestyle. How solid, then, is America’s economic recovery? … [not] safe at all.”

I remember reading this column in 2005 and thinking “Oh, dear.” As a summary of America’s economy in the 00’s it holds up rather well, no? In light of this column, I find Alex’s quibbling with Krugman’s effort to explain the social history of macroeconomists to NYT readers as “simplified” to be unhelpful. Krugman broadly got things right then and now AFAICT.

23 Lord September 14, 2009 at 8:29 pm

The problem is if prices aren’t always correct, what is the market efficient at? Subterfuge? It really becomes a meaningless concept.

24 Cowboy Way Econ Rodeo September 15, 2009 at 12:47 am

“asset” = fixed
“value” = > or < a stone is a stone until you need to build a dam

25 Barkley Rosser September 16, 2009 at 3:38 pm


Declaring something to be “pathetic” without any explanation of why is
itself the very depths of arrogant pathos.

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