Krugman’s Simplified History

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.


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