How Did Economists Get It So Wrong?

In diesem Artikel geht es in Englisch um einen Überblick über die Wirtschaftskrise.

I have published here several articles about the current economic crisis, and the reasons, which led to it. With my delicious bookmarks, I offer you additional material and information about this topic:

The focus of my articles on this crisis is narrative, and has the following objective:

  • I concentrate on the overview over this topic and sometimes add own detailed analysis.
  • I try to understand the economic-crisis, and I think about its implications to product management.

How Did Economists Get It So Wrong?

These days Paul Krugman has published the long-awaited theoretic explanation of this crisis. You find his article, and the related material, as follows:

The current economic crisis is also caused by wrong recommendations given by economists to policy makers. These wrong recommendations are partly the result of imperfect economic theories. The article and the related discussions are a must read, if you are interested in the following type of insight:

  • You want to gain an understanding of the theoretic background, which led to this crisis,
  • You want to learn about the defects of the economic theories,
  • You want to understand the future needs for economics as a science.


My personal key takeaways from his work are as follows:

  • As a profession, the economists „mistook beauty, clad in impressive-looking mathematics, for truth“ (Krugman).
  • The models, which were used by economists, oversimplified the real world. The economist profession in particular wrongly worked with the assumption that markets were perfect, and the economic subjects were rational. In the reality, markets have defects (thus not always finding an equilibrium between demand and supply), and individuals might act like irrational crowds – in particular if they panic.
  • Since Adam Smith, the basic message of economic thinking was that we should trust the market. The first economic crisis 1929 already showed that this rule was partially wrong. Keynes thought that market failure was responsible for this crisis. In his eyes, the market failed, because financial markets are dominated by short-term speculation rather than long-term considerations. He suggested the government to take a special role in periods of economic downturn. Friedman counterattacked his theory beginning with the 1950ie with the doctrine known as monetarism. The basic idea of the latter thinking is that the government should keep out, and (instead) trust the markets – an idea, which has proven to be wrong in the meantime.
  • The economic sciences offered models, such as the Capital Asset Pricing Model (CAPM), which were widely used to support real-world decisions. The CAPM model is able to support the selection of a portfolio of equities, and which was is able to calculate prices for derivatives.
  • The „freshwater economists“ (neoclassical purists) start their economic analysis from the premise of rational people, and working markets. Using his example of the Capitol Hill Baby Sitting Co-op (also used in other occasions), he explains that the latter premise is violated. The „saltwater economists“, such as Mankiew, Blanchard, or Romer on the other hand were willing to deviate from this assumption of perfect rationality, and perfect markets. Interestingly, for a long time, both schools just disputed about theory, not action.
  • For a long time, the economic science had „a general belief that bubbles just do not happen„. In this context he uses the parable of the ketchup economy to show that even careful and rational buyers can not verify if price-levels are justified (as it happened with the home buyers in the US), so that it is possible for bubbles to occur. The ketchup economy says „because a two-quart bottle of ketchup costs twice as much as a one-quart bottle, finance theorists declare that the price of ketchup must be right“ (Krugman)
  • „Economics, as a field, got in trouble because economists were seduced by the vision of a perfect, frictionless market system“ (Krugman). In reality, many investors do not even take into account the efficient-market theory, but they are often subject to herd behavior. Secondly, those who do so find that they can’t, due to problems of trust, credibility, etc.

Future Direction

Krugman thinks that the profession will need to take the following direction:

  • Accept that markets are imperfect, and subject to delusions and the madness of crowds.
  • Accept Keynes framework as the best framework for recessions and depressions.
  • Incorporate the realities of finance with macroeconomics.

Further Ideas

Krugman’s article follows the same lines as a recent discussion about Keynes and new Keynes in the German Handelsblatt (, so that it is feasible to asume that Keynes ideas are about to be revived. As far as I have followed this discussion: This time it would be very important for the Goverments, to fully understand Keynes. He basically suggested governments to issue debt to secure demand during recessions, and to save during better times. In the 1970ies Governments started to issue debt independently from the economic cycle.

In a different paper was written that there were several economists who already this time warned that a crisis is possible. As the mainstream thinking was differently, these economics were not taken for full. In future, I think, it would be helpful for economics as a profession to avoid herd thinking also there. Instead there needs to be a favorable climate for critical voices to be heard.

Often, the economic theory talks about markets, and market participants. In the context of global finance, I think, that it is helpful to keep in mind the particular role, which computers play nowadays. Most banks use software from few vendors, and they furthermore customize these systems in a way that they can take decisions on their own. During downturn, these stop-loss marks, the automated trading decisions of computers, together with the internet, might affect the markets, or might lead to a very rapid herd behavior. I think that new theories should therefore not only accept that markets are imperfect. They should incorporate the special role of computerized decision processes.

Weiterführende Informationen

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