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Robert Lucas on facile criticisms of economics in the face of the GFC.

Here. We are getting glib critiques of economics (and particularly of the EMH) in the wake of the fast-receding GFC.  RL sets things straight.

Let me take an excerpt from The Economist:

“One thing we are not going to have, now or ever, is a set of models that forecasts 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.)

Mr Fama arrived at the EMH through some simple theoretical examples. This simplicity was criticised in The Economist’s briefing, as though the EMH applied only to these hypothetical cases. But Mr Fama tested the predictions of the EMH on the behaviour of actual prices. These tests could have come out either way, but they came out very favourably. His empirical work was novel and carefully executed. It has been thoroughly challenged by a flood of criticism which has served mainly to confirm the accuracy of the hypothesis. Over the years exceptions and “anomalies” have been discovered (even tiny departures are interesting if you are managing enough money) but for the purposes of macroeconomic analysis and forecasting these departures are too small to matter. The main lesson we should take away from the EMH for policymaking purposes is the futility of trying to deal with crises and recessions by finding central bankers and regulators who can identify and puncture bubbles. If these people exist, we will not be able to afford them. (my bold)

The Economist’s briefing also cited as an example of macroeconomic failure the “reassuring” simulations that Frederic Mishkin, then a governor of the Federal Reserve, presented in the summer of 2007. The charge is that the Fed’s FRB/US forecasting model failed to predict the events of September 2008. Yet the simulations were not presented as assurance that no crisis would occur, but as a forecast of what could be expected conditional on a crisis not occurring. Until the Lehman failure the recession was pretty typical of the modest downturns of the post-war period. There was a recession under way, led by the decline in housing construction. Mr Mishkin’s forecast was a reasonable estimate of what would have followed if the housing decline had continued to be the only or the main factor involved in the economic downturn. After the Lehman bankruptcy, too, models very like the one Mr Mishkin had used, combined with new information, gave what turned out to be very accurate estimates of the private-spending reductions that ensued over the next two quarters. When Ben Bernanke, the chairman of the Fed, warned Hank Paulson, the then treasury secretary, of the economic danger facing America immediately after Lehman’s failure, he knew what he was talking about.

Mr Mishkin recognised the potential for a financial crisis in 2007, of course. Mr Bernanke certainly did as well. But recommending pre-emptive monetary policies on the scale of the policies that were applied later on would have been like turning abruptly off the road because of the potential for someone suddenly to swerve head-on into your lane. The best and only realistic thing you can do in this context is to keep your eyes open and hope for the best.

After Lehman collapsed and the potential for crisis had become a reality, the situation was completely altered. The interest on Treasury bills was close to zero, and those who viewed interest-rate reductions as the only stimulus available to the Fed thought that monetary policy was now exhausted. But Mr Bernanke immediately switched gears, began pumping cash into the banking system, and convinced the Treasury to do the same. Commercial-bank reserves grew from $50 billion at the time of the Lehman failure to something like $800 billion by the end of the year. The injection of Troubled Asset Relief Programme funds added more money to the financial system.

There is understandable controversy about many aspects of these actions but they had the great advantages of speed and reversibility. My own view, as expressed elsewhere, is that these policies were central to relieving a fear-driven rush to liquidity and so alleviating (if only partially) the perceived need for consumers and businesses to reduce spending. The recession is now under control and no responsible forecasters see anything remotely like the 1929-33 contraction in America on the horizon. This outcome did not have to happen, but it did.

Both Mr Bernanke and Mr Mishkin are in the mainstream of what one critic cited in The Economist’s briefing calls a “Dark Age of macroeconomics”. They are exponents and creative builders of dynamic models and have taught these “spectacularly useless” tools, directly and through textbooks that have become industry standards, to generations of students. Over the past two years they (and many other accomplished macroeconomists) have been centrally involved in responding to the most difficult American economic crisis since the 1930s. They have forecasted what can be forecast and formulated contingency plans ready for use when unforeseeable shocks occurred. They and their colleagues have drawn on recently developed theoretical models when they judged them to have something to contribute. They have drawn on the ideas and research of Keynes from the 1930s, of Friedman and Schwartz in the 1960s, and of many others. I simply see no connection between the reality of the macroeconomics that these people represent and the caricature provided by the critics whose views dominated The Economist’s briefing”.

5 comments to Robert Lucas on facile criticisms of economics in the face of the GFC.

  • Sinclair Davidson

    Good find – that’s fantastic

  • JSav

    It’s a very good point. Bill Easterly just wrote in his blog:

    “Your Majesty, economists did something even better than predict the crisis. We correctly predicted that we would not be able to predict it.”

    http://blogs.nyu.edu/fas/dri/aidwatch/2009/08/the_idiots_guide_to_answering.html

  • Uncle Milton

    It’s a good article by Lucas, but it’s demolishing a straw man. The failure of economics was not the inability to predict the crisis, any more than the failure of astronomers to predict the meteorite that recently hit Jupiter was a failure of astrophysics.

    The real failure of economics is its failure to coherently explain what happened even after the event. As Brad de Long has pointed, you can’t find find an explanation for the GFC, in terms of a logical macroeconomic model, at any level in economics. Not in an elementary textbook, not in an advanced textbook and not in the literature. Like in the 1930s and like in the 1970s, macroeconomics is going to have to be rebuilt brick by brick.

  • hc

    Ex post there was a bubble that was really difficult to pick and, as occurs in most booms, people got lax and dishonest in their capital market dealings. There was ‘irrational exhuberance’. Maybe there is no formal economic model – Keynes’ emphasis on will-of-the-wisp autonomous investments comes close – but I think Trevor Sykes described what happens pretty well in The Money Miners. The GFC was just a big boom that lasted a long-time and which went very bad.

    As Sykes liked to remark “Did you hear that?”

    “Hear what?”

    “That bell that just rang telling you that the great game of shuffling over-valued assets has ended, that auditors will be called to account, and that corporate sleezes will fall back on their hidden reserves”.

  • Uncle Milton

    Harry, the financial bubble part is not difficult to explain. How and why the real economy got hit as a result of the bubble bursting is much harder. Why did this bursting bubble kill economies when the bursting of the dot come bubble such little effect?

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