Efficient Market Theory Gets Smacked Down

Paul Krugman in the Sunday New York Times offers an insightful smack down of the Chicago School of macroeconomics and the efficient market theory that forms a foundation of index investing. The basic question in How Did Economists Get is So Wrong? is how did the economists completely fail to predict the financial crisis?

Krugman says the Chicago economists are the product of a Dark Age of macroeconomics in which hard-won knowledge has been forgotten and quotes Brad DeLong of the University of California, Berkeley, about the “intellectual collapse” of the Chicago School. Krugman points to Robert Shiller, an economics professor at Yale, the author of Irrational Exhuberance and a partner at the ETF firm MacroMarkets, as one of the few economists to get it right.

Krugman says economics needs to go back to the great economist of the Great Depression: John Maynard Keynes for an explanation of what had happened and a solution to future depressions.

Keynes, who called the financial markets a casino, “did not, despite what you may have heard, want the government to run the economy. He described his analysis in his 1936 masterwork, “The General Theory of Employment, Interest and Money,” as “moderately conservative in its implications.” Krugaman says, “he wanted to fix capitalism, not replace it. But he did challenge the notion that free-market economies can function without a minder, expressing particular contempt for financial markets, which he viewed as being dominated by short-term speculation with little regard for fundamentals. And he called for active government intervention — printing more money and, if necessary, spending heavily on public works — to fight unemployment during slumps.”

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