The above links to a 13-page, 6,700-word summary of economic history and theory that is elegant and sobering. I liked that, in my own actuarial work over 45 years, having needed the occasional "fudge factor" seems less irrational now that Paul Krugman has introduced a "fudge factor" into his models! Derivative pricing can't be done without CAPM, despite Paul's showing that CAPM is not the whole story, so I suspect actuarial employment in this area will continue, albeit with less faith in derivatives based on data mining produced "somewhat strong correlations."
The following is a paraphrase of the article -- 600 words rather than 6,700. Krugman looks at the idea that fiscal policy is not useful - markets were inherently stable — indeed, that stocks and other assets were always priced just right, and the idea that Obama’s Keynes theory based stimulus is based, as Lucas says, on “schlock economics,” or as his Chicago colleague John Cochrane says, based on discredited “fairy tales,” a popular idea in the heartland (“freshwater”) economic departments.
Milton Friedman of the University of Chicago pushed monetary policy, the Fed controlling the cash in circulation, as the only weapon to help the economy, making the government haters over at Fox News very happy as they could, as they today did, claim that the stimulus did not work. Indeed Friedman’s collaborator, Anna Schwartz, once argued that if the Federal Reserve had done its job properly, the Great Depression would not have happened.
Many of the new Keynes rejectionists over in the GOP and on Fox actually view recessions as a possibly a good thing, part of the economy’s adjustment to change, and that we do more harm than good with any attempt to fight an economic slump. Let the “efficient-market” of Eugene Fama of the University of Chicago work it all out. After all there are all these statistics that compare assets prices “proving” the “efficient-market” -- statistics mocked by Larry Summers, Director of the White House's National Economic Council, who noted that all they were saying was “two-quart bottles of ketchup invariably sell for exactly twice as much as one-quart bottles of ketchup,” ignoring the limitations of human rationality that often lead to bubbles and busts.
Keynes rejected the idea that one should have the government run the economy, wanting only to fix capitalism -- printing more money, and, if necessary, spending heavily on public works -- to fight unemployment during slumps, and that is the position of most economist in the economic departments in schools on either coasts (the “saltwater” schools). Keynesian economics has been “proved false,” says Cochrane, of the University of Chicago, because lack of demand can not happen -- prices will always adjust. Nobel laureate Robert Lucas argued that recessions were caused by temporary confusion: workers and companies had trouble distinguishing overall changes in the level of prices because of inflation or deflation from changes in their own particular business situation. And, Edward Prescott, of the University of Minnesota, argued that price fluctuations and changes in demand actually had nothing to do with the business cycle, that we were seeing the rational response of workers, who voluntarily work more when the environment is favorable and less when it’s unfavorable: Unemployment is a deliberate decision by workers to take time off -- the Great Depression was really the Great Vacation.
Chicago’s Casey Mulligan buys the idea that the social safety net causes unemployment to be high as workers are choosing not to take jobs in response to “financial incentives that encourage them not to work,” suggesting they are unemployed because that improves their odds of receiving mortgage relief. And Cochrane declares that high unemployment is actually good: “We should have a recession. People who spend their lives pounding nails in Nevada need something else to do.”
Even Ben Bernanke said in 2005 said that home-price increases “largely reflect strong economic fundamentals,” meaning home buyers generally do carefully compare prices with the prices of other houses. Krugman notes this is again ketchup economics, where 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. Nothing is ever said about whether the overall price of houses is justified. Krugman concludes that behavioral finance theories, efficient market theory with fudge factors to adjust to real human behavior, are the correct approach for economists as they accept that sometimes humans just have to run with the herd.
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William Chirolas brings 40 years of real-world business experience in local, state, national, and international tax, pensions, and finance to the world of blogging. A graduate of MIT, he calls the Boston area home, except when visiting kids and grandkids.
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