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My Lucas Critique

August 7, 2009

Mario Rizzo has an interesting take on Robert Lucas’ recent essay on prediction of business cycles.

Lucas’ post is quite an odd defense of the mainstream economics gurus who were caught flat-footed. Here are some good excerpts:

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.

This is far too clever and slippery. Someone can evaluate a situation as unsustainable (or poised in an “unstable equilibrium”) without being able to predict exactly when the break will occur. Lucas’ logic strikes me as similar to when game theorists stubbornly say what the “rational” strategy is, even though the commonsense strategy pays more in practice. (Believe it or not, I think Brad DeLong and I are in basic agreement regarding Lucas.)

Also, without in any way justifying my claim, let me just throw it out there that I’m starting to think the efficient markets hypothesis is a state of mind, a consciously chosen way of looking at the world. I’m not sure what it would mean to really falsify it. It seems that any attempt to test it would rely on assumptions about seemingly random events, which in the final analysis would mean you weren’t really testing the efficient markets hypothesis alone.

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