Paul Krugman: When Basic Economic Theory Is Ignored, Disaster Will Follow

As I have been writing a lot lately, the clean little secret of the global economic crisis is that standard economic theory actually performed pretty well.

It's true that few anticipated the severity of the 2008 crisis — but that wasn't a deep failure of theory, it was a failure of observation. We actually had a pretty good understanding of bank runs; we just failed to notice that traditional banks were a much smaller share of the system than before, and that unregulated, unguaranteed shadow banks had become so important. Once that realization hit, as the economist Gary Gorton has documented, standard bank-run theory made perfectly good sense of the story.