Economists on the Defensive--Robert Lucas

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.

Lucas argues that until the collapse of Lehman Brothers, the risk of a financial crisis was so small that to have recommended "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." That is a poor analogy. The probability of such a sudden swerve is too small to justify not driving. The financial crisis had been building since mid-2007 and had turned acute in March 2008 with the collapse of Bear Stearns, yet the Federal Reserve and most economists (including Lucas) did not believe that the risk of a financial collapse was serious. They didn't see a crisis that was swerving head-on into their lane.

Indeed, a few days after Lehman collapsed, Lucas expressed skepticism that the economy would slip into a recession. A few days before the collapse he had expressed skepticism that the subprime mortgage crisis would contaminate the entire mortgage market. Even though he disbelieves in forecasts, he was making forecasts, and they were erroneous.

Lucas says in his article in the Economist that the Federal Reserve saved the day by pumping cash into the banking system and persuading the Treasury Department to do likewise. He does not mention the other measures taken by government. He praises Ben Bernanke, the chairman of the Fed, for having "formulated contingency plans ready for use when unforeseeable shocks occurred." In fact the Fed had no contingency plans for the housing and stock market shocks that rocked the economy. Its response when the shocks hit with full force last September was prompt, but also improvised and spasmodic--hence the failure to bail out Lehman Brothers, a failure that deepened the financial crisis by seizing up the commercial paper market.

That was one blunder Bernanke made, and there are others, none of which Lucas--who is unstinting in his praise of Bernanke--mentions. Nouriel Roubini, while urging Bernanke's reappointment as Fed chairman, notes (in "The Great Preventer," in the New York Times of July 25) that Bernanke "supported flawed policies when Alan Greenspan pushed the federal funds rate...too low for too long and failed to monitor mortgage lending properly, thus creating the housing and credit and mortgage bubbles"; "kept arguing that the housing recession would bottom out soon"; "argued that the subprime problem was a contained problem when in fact it was a symptom of the biggest leverage and credit bubble in American history"; "argued that the collapse in the housing market would nto lead to a recession"; "argued that monetary policy should not be used to control asset bubbles"' and "attributed the large United States current account deficits to a savings glut in China and emerging markets, understating the role that excessive fiscal deficits and debt accumulation by American households and the finanical systems played." These mistakes are surprising, since Bernanke is the leading economics student of the Great Depression of the 1930s.

Robert Lucas, because of his distinction, and because of his famous (or should it be notorious?) statement in 2003 that macroeconomists had solved "the central problem of depression-prevention" and should move on to other subjects, contributed to the economics profession's, and the government's, complacency about the vulnerability of the economy to severe crashes, and contributed also to deflecting economists from improving their understanding of the risks of economic instability.

But the mistakes of Lucas and Bernanke and Fama and other leading macro- and financial economists should not be regarded as personal failings. The three I have named and others I could name really are brilliant economists. Their mistakes largely reflect the inherent difficulty of the economic issues with which their specialized fields of economics wrestle. This is important to understand so that we do not exaggerate the contribution that the economics profession, at least as constituted and oriented at present, can make to averting economic calamity.