As a scientist I am familiar with the process by which scientific knowledge develops, at least in my own field. This understanding gives me some insight into what has gone wrong with economic theory.
Knowledge begins with a set of generally accepted observations about how something works, based on actual data, and this forms the basis of a model or hypothesis. Typically this model will have some assumptions built into it. Much of the debate will centre around (1) whether the assumptions are correct and (2) whether the model explains new data that comes in. Ideally an experiment should be performed and/or new data collected to test a prediction of the model. A model that explains new data and makes correct predictions will continue to be supported.
Conversely, if new data emerges that challenges the model then it should be revised. When revising the model it is also important to reconsider whether the assumptions are correct. Often a model is refined without changing the assumptions. The longer a model is accepted the more difficult it is to convince people to change the underlying assumptions.
The current models of how the economy as a whole functions are termed dynamic stochastic general equilibrium models (DSGE). The global financial crisis demonstrated clearly that DSGE models are wrong. They did not predict the financial crisis, they do not explain what is happening now, and they provide no clear route out of the crisis. The eurozone is modelled using a DSGE model. That has not gone very well!
When individuals have built their careers on particular models it is naturally very difficult for them to accept that they are wrong. They usually don't. Typically they come up with all sorts of special explanations as to what has happened. They try to preserve the essence of their model or come up with their own revision of the model that enables them to preserve their own reputation or prestige.
These people will tend to fight revisions by ignoring dissenting opinions or subjecting them to particularly harsh peer review. This is not necessarily a vindictive or even conscious process. It is a natural human instinct. If the discipline is dominated by such people it can take some time before incorrect models are revised. Sometimes it requires a generational change - i.e. the people have to change.
I have experienced this myself in my own field. Those proposing that T cells have a regulatory or suppressive role were largely ignored and marginalised for almost two decades despite publishing clear evidence. Only when a new generation emerged who were free to consider the evidence at face value and had not staked their reputation on rejecting regulatory T cells was the reality of regulatory T cells widely accepted.
Paul Krugman, like other neoclassical economists, supports dynamic stochastic general equilibrium models. One key assumption of these models is that banks play an insignificant role and can be omitted from the model. They are assumed to be just financial intermediaries, there for convenience. This largely explains why they were unable predict the global financial crisis, which was the result of an unsustainable accumulation of private debt (as a result of excessive commercial bank lending) and the eventual collapse of the resulting asset price bubble.
Many outside this consensus, such a Steven Keen, have long argued that commercial banking must be included in any economic models, if for no other reason that in modern economies, in which governments, like all other agents, are meant to balance their books, banks drive the process by creating new money when they make loans. This is a fact widely confirmed by central banks and bankers themselves. However, accepting this simple fact - that banks create money out of thin air - fatally undermines the models that neoclassical economist have long defended and staked their reputations on. That is why they are so reluctant to accept this aspect of reality.
In a series of blog exchanges between Paul Krugman and Steven Keen this debate has been played out. If you read the exchange it is clear that Krugman lost.
I greatly admire the man for his liberal views, and for asserting consistently that budget deficits are what are needed at this moment. If he is able to accept that he is wrong about the role and significance of commercial banks my admiration will have no limit.
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