Arguing with Zombies — Paul Krugman on Bad Models and False Idols

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Arguing with Zombies — Paul Krugman on Bad Models and False Idols

Economics was solved

Most experts did not see the Global Financial Crisis coming until it happened. Many economists at the time believed that protracted recessions, at least for advanced economies, were things of the past. Their mathematical models and theories had supposedly conquered the economic machine. In Macroeconomic Priorities (2003), Nobel laureate Robert Lucas pronounced, for instance, that the “central problem of depression prevention has been solved, for all practical purposes.” 

Similarly, in 2004, then chairman of the Federal Reserve Alan Greenspan argued likewise that price distortions in housing were “most unlikely.” Even in 2007, another Nobel laureate, Eugene Fama, who helped to birth the efficient market hypothesis, said in an interview that “the word ‘bubble’ drives [him] nuts.” And while he wasn’t sure whether the housing market was efficient or not, he said that “people are very careful when they buy houses.”

Indeed, such sentiments have aged poorly. In Arguing with Zombies, Paul Krugman says that economics was “seduced by the vision of a perfect, frictionless market system.” It “mistook beauty, clad in impressive-looking mathematics, for truth.” And the economists in positions of influence, like Greenspan, Fama, and Lucas, had ignored our bounded rationality and Friedrich Hayek’s warning that statistics are sometimes illusive. Aggregate stability may hide the instability that festers in the details.

Moreover, in financial economics, as Krugman observes, “[John Maynard] Keynes’s disparaging vision of financial markets as a “casino” was replaced by ‘efficient market’ theory, which asserted that financial markets always get asset prices right given the available information.” The problem is that if your starting assumption is that markets are mostly efficient, it is easy to rationalize the unfolding absurdity as perfectly sensible.

Dumb money

To be fair, some economists did warn of impending danger. Robert Shiller, for example, has written plenty about the epidemiology of investor sentiment and irrational exuberance. Krugman likewise points to Paul McCulley, who opined in 2001 that “there is room for the Fed to create a bubble in housing prices, if necessary, to sustain American hedonism.”

Not long after, Raghuram Rajan (2005) warned that while financial development improved risk management and access to capital, it may also spur greater risk taking. And if every corporation and institution is taking on “small probability risks”, then the collective economy “may be more exposed to financial-sector-induced turmoil than in the past.”

Similarly, in Inefficient Markets, Andrei Shleifer notes that investors and traders are susceptible to a litany of behavioral biases. They include inattention, herding, conservatism (i.e., slow to update beliefs) and representativeness (i.e., over-extrapolating from small samples). The anatomy of a price bubble, he adds, often depends on visceral narratives, perceived innovations, “authoritative blessings”, and self-reinforcing expectations.

Moreover, arbitrage may not be enough to eliminate mispricing as is commonly assumed by orthodox finance. As Keynes famously said, “markets can stay irrational longer than you can stay solvent.” For one, the capital necessary for arbitrage can evaporate when markets are in freefall. And even if the irrational investors underperforms and closes shop, ‘smart money’ may not crowd out the ‘dumb money’. As Shleifer reminds, new fools and fads are born every year. They restart the frenzy anew.

Fundamental instability

Krugman himself admits that while he saw the housing bubble, he “had not realized how vulnerable our financial system had become.” This was hidden in part by the opaqueness of financial innovation. Even the trader George Soros, who anticipated the market’s reaction during the subprime meltdown, underestimated its volatility and took too large a position. He “learned the hard way that the range of uncertainty is also uncertain.”

Since the crisis, Krugman has grown to believe that a “moderate economic policy regime… is inherently unstable.” Hyman Minsky’s financial instability hypothesis suggests a similar thing—that financial and capital markets tend to transition from safety to speculation to Ponzi-like and back-again. Krugman agrees but suggests that there’s more to it. He observes, in particular, that “the very success of central-bank-led stabilization, combined with financial deregulation… set the stage for a crisis too big for the central banks to handle.”

False idols

But when the housing bubble popped, the peddlers on Wall Street walked away with their fat commissions as Main Street paid and suffered for the damages. Krugman wonders if the excesses of finance is really just a quasi-Ponzi scheme cloaked behind the veil of so-called financial innovation. This is a troubling thought because finance and insurance today accounts for around eight percent of American output. But it is not easy to say how much of it is truly value creation, value destruction, or value transfer, Krugman notes. Yet the sector is often held in high esteem. People pay more attention to financial gurus on Youtube and Tik Tok than to their local scientists. As Krugman writes, it reflects “an innate tendency… to idolize men who [make] a lot of money, and assume that they know what they’re doing.”

Keynesian monsters

Unfortunately, idolization of the wealthy is just one of the many bad habituations and heuristics that people continue to cling to in economics and finance. Another ‘persistent zombie’ in the United States, Krugman writes, “is the insistence that taxing the wealthy is hugely destructive to the economy”, or that “safety-net programs are harmful and unworkable.” This is despite the fact that the opposite has been shown to be true in advanced economies around the world.

Similarly, another myth is the belief that any form of deficit spending is always economically untenable. As Krugman explains, we have to remember that “the economy isn’t like an individual family.” Somebody’s spending is somebody else’s income. But if everyone is tightening their pockets, the economy will tip into recession—which may lead to a further tightening of pockets and rises in unemployment. Sometimes, government intervention is necessary as a countervailing force. Yes, Krugman agrees that “in normal times, modesty and prudence in policy goals are good things.” But such restraint may have to wait until employment levels return to good health. We might otherwise not have an economy to restrain our spending on.

Now, even if fiscal stimulus or monetary policy does not restore the economy to full employment right away, it does not mean that the initiative failed. Perhaps the situation might have been more dire had there been no intervention in the first place. When it comes to economic interactions, we must always pay attention to confounding variables and to counterfactual histories.

Values and sycophants

Still, eradicating zombie ideas in economics and finance will not be easy. The whole thing is muddied by politicization and “bad faith”. Krugman reminds us, for instance, that there are two types of economists: the conservative professional and the professional conservative (or equally, the liberal professional and professional liberal). This distinction is important. Conservative professionals, Krugman explains, attempt “to understand the economy as best they can, but who, being human, also have political preferences.”

Professional conservatives, on the other hand, are “charlatans and cranks [who] make a living by pretending to do actual economics… but are actually just propagandists.” They are sycophants who will disregard truth and discourse in pursuit of political favour and association. Unfortunately, in the age of rapid media and one line zingers, it can be difficult to distinguish between the two camps.

In the end, we should remember, Krugman adds, that “everything is political”, and that the “axis of contention is [often] about values.” While “economics can’t tell [us] what values to have,” it can help us to assess and compare our choices, actions and policies based on the beliefs and values we harbor. But to do this well, we must not forget some basic rules in social punditry, says Krugman. In particular, we should “use plain language”, “talk about motives,” and “be honest about dishonesty.” We otherwise risk perpetuating “[zombie] ideas that should have been killed by contrary evidence, but instead keep shambling along, eating people’s brains.”

“When I was young and naïve, I believed that important people took positions based on careful consideration of the options. Now I know better. Much of what Serious People believe rests on prejudices, not analysis. And these prejudices are subject to fads and fashions.”

Paul Krugman. (2020). Arguing with Zombies.

Sources and further reading