Friday, August 07, 2009
In a guest article at the The Economist, in response to at least three less-than-flattering assessments of the profession in recent weeks, Chicago University Economic Professor Robert Lucas defends economic models and their contributions to Mankind.
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.How about throwing out all of the failed models along with efficient market theory and setting a modest goal of looking at how asset prices and people interact in an effort to spot the next giant speculative bubble before it destroys the world?
It didn't take any models or elaborate theories to conclude that when Fannie and Freddie couldn't file financial statements back in 2003 due to their use of derivatives, there was something seriously wrong and the correct remedy was not to outsource their operations to Wall Street, away from the prying eyes of regulators.
When in 2005 and 2006, mortgage lenders joked that "anyone who could fog a mirror could get a loan", it was already too late, but the damage done in 2008 might have been mitigted if these activities were not broadly characterized as "financial innovation" amongst economists.