“There is widespread disappointment with economists now because we did not forecast or prevent the financial crisis of 2008. The Economist's articles of July 18th on the state of economics ... caricatured [macroeconomists] as a lost generation educated in the use of valueless, even harmful, mathematical models, an education that made them incapable of conducting sensible economic policy. I think this caricature is nonsense ....
One thing we are not going to have, now or ever, is a set of models that forecast sudden falls in the value of financial assets, like the declines that followed the failure of Lehman Brothers in September. This is nothing new. It has been known for more than 40 years and is one of the main implications of Eugene Fama's "efficient-market hypothesis" (EMH), which states that the price of a financial asset reflects all relevant, generally available information.
If an economist had a formula that could reliably forecast crises a week in advance, say, then that formula would become part of generally available information and prices would fall a week earlier. (The term "efficient" as used here means that individuals use information in their own private interest. It has nothing to do with socially desirable pricing; people often confuse the two.)”
Robert Lucas, "In defence of the dismal science", The Economist (8 August 2009).
www.economist.com/businessfinance/displaystory.cfm?story_id=14165405
University of Chicago economist Robert Lucas (1937-), one of the most influential economists in the world, received the Nobel Prize in 1995. His ex-wife had a clause placed in their 1988 divorce settlement that she would receive half of any Nobel Prize won by Lucas in the next seven years. To her delight, Lucas won the prize just within the time limit.
In this article, Lucas defends economics -- and economists -- against criticisms that the financial crisis represents a failure of 'the dismal science'.
Comments of other prominent economists -- Robert J. Barro, Mark Thoma, Tyler Cowen, Markus Brunnermeier and Brad DeLong -- are posted at www.economist.com/blogs/freeexchange/lucas_roundtable/, along with a reply by Lucas to what he considers to be an inaccurate statement of DeLong regarding Lucas' opinion of Fed Chairman Ben Bernanke.
Needless to say, the failure of the economics profession in general and macroeconomists in particular to foresee the depth and severity of the current downturn has generated much debate in the profession itself. This debate is all the more heated because not just because different points of view and political positions are at stake, but reputations as well. Egos have been bruised, and it will take some time for passions to subside.
There will also have to be a dispassionate reassessment of macroeconomic theory and its usefulness for policy purposes. That, however, will take some time and must involve people who have not been at the center of the development of current theory and policy. They will also have to work step-by-step from the ground up, assessing the usefulness of elements such as the “efficient-market-hypothesis” (the assertion that prices on financial markets, e.g., stocks, bonds, property, already reflect all known information and instantly change to reflect new information) and the degree to which “sticky prices” (the assertion that microeconomic prices and wages are resistant to change), as another example, hinder the macroeconomic adjustment process. We will have to move beyond simple ideas like these that underlie the controversies about contemporary macroeconomic theory and policy.
While I am in sympathy with much of what Professor Lucas has to say, I do think macroeconomic theory is now in shambles. That does not mean we will stop teaching it in our classes. We macroeconomists do, after all, have to say something about how the macroeconomy operates to earn our pay. But the confidence in our theories has been eroded and our assurance that the deep recessions and horrible depressions of the past are history is now questionable. I think it is fair to say that economists have been wounded more by this crisis than the economy.
Thought du jour has returned from vacation and these missives will be sent once or twice a week until the new semester begins, when its full schedule will resume.
Thanks to Larry Willmore for much of today’s Tdj.
