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The Failure of Economics

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What's in our future -- inflation or deflation?

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As every school child knows, water is formed by the two elements of hydrogen and oxygen in a very simple formula we all know as H2O. Today we start a series that starts with the question: What are the elements that comprise deflation?

Far from being simple, the "equation" for deflation is as complex as that of DNA. And sadly, while the genome project has helped us with great insights into how DNA works, economic analysis is still back in the 1950s when it comes to decoding deflation. Notwithstanding the paucity of understanding we can glean from the dismal science, in this week's letter we'll start thinking about the most fundamentally important question of the day: Is inflation or deflation in our future?

The Failure of Economics

Among the economists and writers I regularly read, there are some who, if they agree with me, I go back and check my assumptions -- I must have been wrong. Paul Krugman is one of those thinkers. I admit to his brilliance, but his left-leaning philosophy doesn't particularly square with mine, and I find that most of the time I disagree with him.

That being said, I strongly encourage you to read his essay in the New York Times Magazine, which came out this past weekend. It's worth the high price of the Times to read it, if you can't get it online. It's a very hard critique and analysis of the failure of current macro and financial economic thought, which didn't even come close to predicting the current financial malaise. Indeed, as he points out, most schools of thought said the state we're in couldn't happen.

Krugman writes, as I have in repeated columns, that we've taught two generations of economists and financial practitioners faulty theories. Even now, believers in the Efficient Market Hypothesis and CAPM hold to their beliefs in the face of clearly contrary evidence.

He calls for a return to, and fresh analysis of Keynesianism. I'd go further: A plague on all their houses. Whether Keynes or Friedman (monetarism) or von Mises (the Austrian school of economics) or the rather new school of behavioral economics, they all have deficiencies and (sometimes gaping) holes in their logic. At the same time, they all contribute to our general understanding of the world, and there are benefits to studying them.

Let me risk an analogy. It's like reading about some religious scheme for interpreting the world and then becoming a true believer, arguing for that point of view as received wisdom -- it's your belief system. Five Nobel laureates say this and seven say that; my guru is smarter than your guru; look at how the math proves this point; and so on.

Krugman concludes:

"So here's what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit -- and this will be very hard for the people who giggled and whispered over Keynes -- that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they'll have to do their best to incorporate the realities of finance into macroeconomics.

"Many economists will find these changes deeply disturbing. It will be a long time, if ever, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. To some economists that will be a reason to cling to neoclassicism, despite its utter failure to make sense of the greatest economic crisis in three generations. This seems, however, like a good time to recall the words of H. L. Mencken: 'There is always an easy solution to every human problem -- neat, plausible and wrong.' "

No positions in stocks mentioned.

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