I Agree With Paul Krugman, but This Time Only!

In the last of his three Lionel Robbins lectures at the London School of Economics on June 30 of this year, Nobel laureate Paul Krugman remarked that the macroeconomic theory of the past thirty years has been “spectacularly useless at best, and positively harmful at worst” (“The Other Worldly Philosophers”, The Economist, July 18–24, 2009, p. 65).

Professor Krugman was referring to the economics profession’s failure to predict the onset of the current global financial crisis and its inability to supply sound policy recommendations for responding to it.

But his justifiable criticism of macroeconomic theory ignores, as most of the profession has, the elephant in the room.

Orthodox macroeconomists, with the exception of Robert Lucas and a handful of other theorists, have adopted a Keynesian (or so-called neo-Keynesian) perspective on the world that commits two disastrous errors. One of the errors is that government can be assumed to be exogenous to the macro-economy and therefore is able to intervene surgically to “fine-tune” it. The other error is that important macroeconomic aggregates, such the level of prices, of national income, and the rate of employment (or unemployment), are taken as objects of affirmative choice for governmental decision-makers

Those two errors commit what Friedrich Hayek calls the “fatal conceit” of socialism. Government policy is, in fact, endogenous—the Keynesian perspective would be worthless if fiscal and monetary policies did not respond appropriately to the private economy’s observed macroeconomic performance. What is more important, macroeconomic aggregates—GDP and the rates of inflation or unemployment—are determined not by government policy but by spontaneous market interactions between hundreds of millions of independently acting individuals. Except in the very short run, government cannot “choose” any of those variables (see, e.g., the essay by George Mason University economist Richard Wagner in The Elgar Companion to Public Choice, 2001).

The uselessness or harmfulness of “modern” macroeconomic theory and it policy prescriptions thus follow not from their mathematical elegance (or lack thereof), but from studious failure to recognize the policy-shaping influence of ordinary politics. Disinterested philosopher-kings do not reside on Harvey Road or anywhere else. Macroeconomists can re-attain positions of policy-relevance only by recognizing that their theories and evidence will be filtered through (and deformed by) politically self-interested policymakers of all political stripes.