Third, Rajan makes an ad hominem attack on Krugman in this article. Worse, he does it by innuendo, implying that Krugman is "paranoid." Rajan and Rogoff have reason to be personally upset with Krugman. Krugman wrote a June 9, 2011 column that explained that Rajan and Rogoff gave spectacularly bad advice not only in favor of fiscal austerity, but raising interest rates, at a time when doing so would have been disastrous and was unsupported by any economic model. Krugman quoted Keynes' famous passage in which he noted that many economists viewed the willingness to inflict misery on others as the hallmark of a real economist.
Round Eight: We Must Focus on Rajan's Admissions
Readers will likely ignore Rajan's column because they will consider his attack on Krugman as an understandable, but disingenuous, payback for Krugman criticisms of the three former IMF economists. That would be a shame, for Rajan's article contains two enormously important admissions that my colleagues who specialize in macroeconomics have long emphasized.
"In the run-up to the 2008 financial crisis, macroeconomists tended to assume away the financial sector in their models of advanced economies. With no significant financial crisis since the Great Depression, it was convenient to take for granted that the financial plumbing worked in the background"."
As Krugman wrote, our focus needs to be on the economics rather than the personalities. Orthodox economics is broken, and Rajan's admissions are what matters in his article.
Theoclassical economists did not simply assume away finance and money. By assuming finance and money away they implicitly assumed away fraud and the essential regulatory cops on the beat. Theoclassical economists pushed to eviscerate the institutional protections such as effective financial regulation and regulators that had helped ensure "that the financial plumbing worked in the background" and created the criminogenic environments that led to the epidemics of control fraud that drive our recurrent, intensifying crises. Economists ignored the warnings and the policies recommended by another Laureate, George Akerlof. Akerlof and Paul Romer wrote a classic article in 1993 entitled "Looting: The Economic Underworld of Bankruptcy for Profit." They made this passage the conclusion of their paper in order to give the message special emphasis.
"The S&L crisis, however, was also caused by misunderstanding. Neither the public nor economists foresaw that the regulations of the 1980s were bound to produce looting. Nor, unaware of the concept, could they have known how serious it would be. Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better. If we learn from experience, history need not repeat itself" (Akerlof & Romer 1993: 60).
Neoclassical economists overwhelmingly continue to ignore Akerlof, Romer, and their former colleague Jim Pierce's findings about control fraud and the findings of criminologists. Rajan's book about the crisis, for example, asserts that fraud played no material role in the crisis and describes a hypothetical scam that he says illustrates the (lawful) causes of the crisis. The scam, however, requires two felonies and would fail as a scam. Rajan does not understand the law or fraud. The accounting control fraud "recipe," by contrast, works and has great explanatory power.