(Late) Monday Smackdown: Robert Lucas Pretends... Edition
(Late) Monday Smackdown: This, from eight years ago, still seems to me to be highly, highly unprofessional:
Robert Lucas (2009): In defence of the dismal science http://www.economist.com/node/14165405: "Fama tested the predictions of the EMH.... These tests could have come out either way...
...but they came out very favourably. His empirical work was novel and carefully executed.... [The] flood of criticism which has served mainly to confirm the accuracy of the hypothesis.... Exceptions and “anomalies”... for the purposes of macroeconomic analysis and forecasting... 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...
As applied to macroeconomic analysis and forecasting, the relevance of the efficient market hypothesis (EMH) rests in what it tells us about the overall level of the stock market—of stock market indexes. In this domain, the EMH claimed that movements in the stock market were driven by one of two things:
- changing rational expectations of future cash flows.
- changing rational expectations of interest rates on investment-grade bonds.
so that when stock indexes made substantial moves, expected returns were one of:
- unchanged.
- moved roughly one-for-one with returns on investment grade bonds.
All of those claims have been totally shredded by reality.
Movements in stock indexes are, overwhelmingly, associated with offsetting movements in future returns. They have, overwhelmingly, no explanation in terms of changing rational expectations of future cash flows. They have, overwhelmingly, no explanation in terms of changing interest rates on long-term bonds. If they have any investor-utility based explanation at all, they must be ascribed to large time variations in risk premia—huge and rapid changes in investors' beliefs about the curvature of their own utility functions.
Or they have no investors utility-based rationale at all.
Yet Robert Lucas claims that the EMH is: perfect, perfect I tell you.
We can and do identify situations of overvaluation. We can and do know that situations of overvaluation are dangerous when any critical mass of key actors are highly leveraged or when any critical mass of key actors are following positive-feedback investment strategies, like portfolio insurance or (cough, cough) risk parity. Identifying situations in which finance poses significant macroeconomic risk is not impossible; it does not require us to hire people "we will not be able to afford" "if they exist".
It just requires that we not be unprofessional...
