Perhaps one of the more important benefits of the financial collapse and the economic depression is that it is forcing economists to re-examine their profession. Well, OK, some economists. And maybe not so much "examine" as just plain old internecine warfare.
Of which we get a good overview from Robert on The Angry Bear, who discusses the battle between "fresh water" (think Chicago) and "salt water" (think anything other than Chicago) macroeconomics.
Roughly Fresh water economists consider general equilibrium models with complete markets and symmetric information to be decent approximations to reality. Unless they are specifically studying bounded rationality they assume rational expectations, that everyone knows and has always known every conceivable conditional probability. I’ve only met one economists who claims to believe that people actually do have rational expectations (and I suspect he was joking). However, the fresh water view is that it usually must be assumed that people have rational expectations.
Over near the Great Lakes there is considerable investigation of models in which the market outcome is Pareto efficient, that is, it is asserted that recessions are optimal and that, if they could be prevented, it would be a mistake to prevent them.
Salt water macroeconomics is basically everything else with huge differences between people who attempt to conduct useful empirical research without using formal economic theory and people who note the fundamental theoretical importance of incomplete markets and of asymmetric information and of imperfect competition (as in everything you think you know about general equilibrium theory is known to be false if markets are incomplete or there is asymmetric information or there is imperfect competition – Market outcomes are generically constrained Pareto inefficient which means that everyone can be made better off by regulations imposed by regulators who don’t know anything not known to market participants who also just restrict economic activity and don’t introduce innovations like, say, unemployment insurance).
Leading fresh water macroeconomists include Robert Lucas, Ed Prescott Thomas Sargent, Lars Hansen, John Cochrane, Larry Jones, Robert Barro (mostly), and Kevin Murphy (usually). Leading salt water economists include Paul Samuelson, Edmund Malinvaud, Jacques Dreze, Joseph Stiglitz, Robert Solow, Paul Krugman, Andrei Shliefer, Olivier Blanchard, George Akerlof, Robert Hall, Ben Bernankle, N. Gregory Mankiw, Christina Romer, David Romer and, and Lawrence Summers. Brad DeLong is also a salt water economist and he is very very smart, but last I knew, he was a little too far out there to be really a member of the economists club. I can’t classify Paul Romer.
Now, this gives me some big problems, there is no way I am willing to put Mankiw on the same side of the room as Krugman. I don't claim to be an economist; I have no desire to be an economist; I just want to make people like Mankiw (who I have always thought of as a radical free marketer in the Chicago mold) either learn something about how us mere mortals have to struggle to make ends meet, or stfu. And it certainly says something that Brad DeLong is not considered a "member of the economists club." Too much interaction with the masses, perhaps?
Robert then observes that there has been a truce between the two bodies of water since the 1980s, even though the fresh water school holds the other body of water in complete contempt. All this Robert has crossed out, with an update stating that the truce has been broken, with a link to Krugman's recent post blasting the Chicago school for having imposed a "dark ages" on economics. More from Krugman, later, but first, the last paragraphs from Robert:
As far as I can tell, fresh water economists have some respect for some thinkers other than fresh water economists. I think they have rather a favorable view of mathematicians and Physicists. I think it would be useful of mathematicians and physicists to look into fresh water macro and express an opinion. On the other hand, in principle they have great respect for general equilibrium theory, but they don’t listen to general equilibrium theorists at all. Top general equilibrium theorists are all at least left of center politically, the closest David Cass could come to naming an exception is Ed Prescott who, he said, uses general equilibrium theory and studies examples (snort).
Finally I have a view of how people can devote so much effort to working out the implications of assumptions which almost no ordinary people would find other than nonsensical if they understood them. Fresh water economics uses difficult mathematical tools. Students in fresh water graduate programs have to learn a huge amount of math very fast. It is not possible to do so if one doesn't set aside all doubt as to the validity of the approach. Once the huge investment has been made it is psychologically difficult to decide that it was wasted. Hence the school gets new disciples by forcing students to follow extremely difficult courses. Last I hear very few graduate students at U Minnesota came from the USA. Undergrads over there know what the program is like. If my information is not out of date, innocents from abroad are the new blood of fresh water economics.
In A Dark Age of macroeconomics (wonkish), Krugman dismantles the economists who came out declaring that stimulus spending does no good because it crowds out private investment. After going through the macro-economic details showing where these stimulus critics go wrong, Krugman concludes;
So how is it possible that distinguished professors believe otherwise?
The answer, I think, is that we’re living in a Dark Age of macroeconomics. Remember, what defined the Dark Ages wasn’t the fact that they were primitive — the Bronze Age was primitive, too. What made the Dark Ages dark was the fact that so much knowledge had been lost, that so much known to the Greeks and Romans had been forgotten by the barbarian kingdoms that followed.
And that’s what seems to have happened to macroeconomics in much of the economics profession. The knowledge that S=I doesn’t imply the Treasury view — the general understanding that macroeconomics is more than supply and demand plus the quantity equation — somehow got lost in much of the profession. I’m tempted to go on and say something about being overrun by barbarians in the grip of an obscurantist faith, but I guess I won’t. Oh wait, I guess I just did.
Ouch. That's gotta hurt.
One final note. Yesterday Stirling Newberry wrote Fundamental Formalisms, in which he posits that there are actually four "formalisms" of economic knowledge: micro-, macro-, meso-, and mega-economics, "with the discipline of econometrics linking them." I won't claim to understand it all, but Newberry has been so consistently correct in his financial and economic prognosis so far ahead of the curve, that I believe it's always worthwhile to try and think through what he is attempting to explain.
The reason for going through this intellectual difficulty is entirely pragmatic: present pushing of strategic calculations into micro-economic terms, and forcing macro-economic policy to meet an illusory micro- equilibrium - more or less, cooking the books - with an unsustainable mega-trend line - more or less, ignoring that we can't pollute and drill for ever - is what lead to our current crisis. The failure to correctly compute and account for strategic equilibria has caused two of our most important financial meltdowns.
I suspect that like DeLong, Newberry is not accepted in the club, but I don't think there are many economists who regularly keep in view fundamental phsyical economic considerations such as "we can't pollute and drill for ever" to inform their larger world-view. (And the failure to keep this view is a big problem - fatal flaw, even - in formal economics, imho.)