Defence is the Last Thing the Dismal Science Needs Right Now

After publishing a parade of articles branding economics as useless for most practical purposes, the Economist finally got a rebuttal out of Robert Lucas. I think he took the hint that the complaint was mainly aimed at Chicago macro rather than macro proper (although the difference between the two can be more or less clear-cut, depending on where you are taught). Lucas said:

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 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.

Now that conclusion sounds pretty dark, even for a dark age. I still struggle to understand the argument though. Prof Lucas's contention is that if there exists a tool that can correctly forecast recession/crisis, then there cannot be a crisis in the first place (the price would have fallen earlier). Hence, proof by contradiction...the fact that Lehman does happen and will happen again, must imply that such a tool cannot exist, ever.

There lies the Achilles heal of the argument. Must Lehman happen again? If there was a tool predicting its calamity, its price would have dropped before Sep 2008. Foreseeing this, Lehman probably would have avoided buying toxic securities. The originators seeing no profit, would have been more careful making subprime loans. And the crisis would never happen. The EMH, conditional on the economists delivering a good set of tool in detecting the eventual crisis, would imply no crisis. And that's what we want!

Whilst private businesses are very good at making money for themselves, they are not too preoccupied with the bigger picture of how their interactions could lead to systemic demise for everyone. After all, that is the job of the economists! To concede that if the market doesn't see it, it is hopeless for economists to work on it, is irresponsible and would indeed push the profession deeper into the dark territory.