Lucas on market forecasting

Robert Lucas, the legendary Nobel-Prize-winning economist and erstwhile CMU professor, has written a great column rebutting a collection of pieces in the Economist on the supposed failure of economics to anticipate the financial crisis. To their credit, the Economist ran the column, which is much better (and shorter) than the pieces it rebuts. Much of it is relevant only as rebuttal, but this point stands on its own:

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.) . . .

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.

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