08 Aug 2009

My Lucas Critique

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Over at the Mises blog–and note that the Mises blog is different from the Mises Daily article–I have a short post about Robert Lucas’ defense of mainstream economics. Lucas basically argued that nobody could have predicted the housing crash, because if they had predicted it by the day before, then it would have happened the day before. And so on. I wrote:

This is far too clever and slippery. Someone can evaluate a situation as unsustainable (or poised in an “unstable equilibrium”) without being able to predict exactly when the break will occur….

Also…I’m starting to think the efficient markets hypothesis is a state of mind, a consciously chosen way of looking at the world. I’m not sure what it would mean to really falsify it. It seems that any attempt to test it would rely on assumptions about seemingly random events, which in the final analysis would mean you weren’t really testing the efficient markets hypothesis alone.

In the comments Troy Camplin argued that, contrary to Lucas, the existence of price bubbles obviously shows the Efficient Markets Hypothesis (EMH) is false. I responded:


Your understanding of what the EMH is, is obviously different from Lucas’. Lucas obviously is aware of what happened to housing prices, and he doesn’t think it violated EMH.

This is partly what I was getting at in my post. I’m pretty sure that Lucas thinks the housing market was hit with a really big shock in 2006, and that made prices fall.

Lucas knows it must have been an unexpected shock, because…(you fill in the blanks).

So my point is that Lucas thinks he just empirically tested whether EMH held up during the housing boom and bust, and he thinks it passed through with flying colors. Yet what wouldn’t pass with flying colors?

Don’t misunderstand, I’m agreeing with you: The housing bubble is a great reason that I personally don’t endorse the EMH. But technically speaking, the EMH is consistent with what just happened. So Lucas isn’t wrong, he just doesn’t realize how a priori his worldview is.

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