Economists on the Defensive--Robert Lucas

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A theme of my blog, as of my book "A Failure of Capitalism: The crisis of '08 and the Descent into Depression," which gives its name to the blog, is the failure of economists to anticipate or even imagine the possibility of the financial collapse of last September, or to agree on how to deal with the collapse. Government officials (many of them economists), business economists, economic journalists, and academic economists alike were, with rare exceptions, taken by surprise by the bursting of the housing bubble (they didn't know it was a bubble), the ensuing banking collapse, the stock market crash, the sharp decline in output and employment, the global scope of the crisis, and the onset of deflation in the late fall of 2008 that created fears of a depression comparable to the Great Depression of the 1930s. The reason for the surprise was that leading macroeconomists and financial economists had believed until last September that there could never be another depression, that asset bubbles are a myth, that a recession can be more or less effortlessly averted by the Fed's reducing the federal funds rate, that the international banking industry was robust, and that our huge national debt was nothing to worry about, nor our very low personal savings rate. All these beliefs have turned out to be mistaken, along with extreme versions of the rational expectations hypothesis, the efficient-markets theory, and real business cycle theory.

 

One of the most distinguished of these economists, Robert Lucas of the University of Chicago, a Nobel prize winner, has just published a short piece in the Economist magazine entitled "In Defence of the Dismal Science" (that is, of economics--dubbed the "dismal science" because of the pessimistic though insightful economic theory of Thomas Malthus).

 

Lucas argues that economists will never develop models that will forecast "sudden falls in the value of financial assets, like the declines that followed the failure of Lehman Brothers in September." The reason is the "efficient markets" theory, which teaches that the prices of financial assets impound the best information about their value. But Lucas's detour into efficient-market theory misses the point. The criticism (my criticism, anyway) of macroeconomists and financial economists is not that they failed to predict that the collapse of Lehman Brothers would lead to a fall in stock prices (they were already falling), but that they disbelieved in asset bubbles. (Eugene Fama, whom Lucas relies on for his remarks on the efficient-markets theory, has been explicit in his disbelief.) So they were not alert to signs that the rise in housing prices in the early 2000s was a bubble phenomenon. Also, because of a lack of knowledge of or interest in institutional detail (a lack that may reflect the increasing mathematization of economics), the economics profession did not understand the degree to which the banking industry (including nonbank banks such as Lehman Brothers) was invested in housing finance and would collapse along with housing prices when the bubble burst. The profession believed, moreover, that at the first sign of trouble the Federal Reserve could avert a serious recession by reducing the federal funds rate through the purchase of short-term Treasury securities from commercial banks. This belief turned out to be completely mistaken.

 

The efficient-markets theory shares with Lucas's distinctive contribution to macroeconomics--the "rational expectations" hypothesis--what appears to be an exaggerated belief in the knowledge and foresight of investors and other economic actors. Not that Fama or Lucas believes that markets are omniscient. The steep rise in oil prices in the wake of the 1973 war of Egypt and Syria against Israel had macroeconomic consequences, yet could not have been foreseen. But that is an example of an external shock. No external shock caused the fall in housing and stock prices and the collapse of the banking industry. The housing bubble, the risky capital structures of the banks, lax regulation, and the low personal savings rate were internal U.S. economic phenomena that had been building for many years. Neither the markets nor the economists foresaw the consequences.

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Richard A. Posner

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. More

Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.
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