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Robert Lucas Abandons the Assumption of Rational Expectations

Hoisted from comments: Chris Carroll of Johns Hopkins writes::

Grasping Reality with Both Hands: Robert Lucas on Non-Standard Monetary Policy: None of the above.

Instead, Lucas is implicitly admitting that he believes the deLong-Peel view that we are currently in the midst of an irrational panic (the degree of risk aversion exhibited by prices in private markets is not justified by any rational calculation). The role of the central bank in a crisis is to step in and drive risk premia down however necessary. Conveniently, if the theory is right, the central bank will ultimately make a tidy profit off this activity.

Of course, he doesn't want to admit this explicitly -- he is Robert Lucas, after all! -- so his piece is "undertheorized" and will remain so. But, as he said somewhere else recently, in a foxhole, everyone is a Keynesian.

And if the theory is wrong, losses on the central bank's portfolio will be among the least of our worries.

One thing I haven't worked out is whether Lucas's theory is that the risk tolerance of the market has collapsed in an irrational manner because of (a) panic, or (b) institutions plus adverse selection. As I said, it is undertheorized.