!A CRITIC ON CONSIDERING THE FINANCIAL CRISIS AS FAILURE OF ECONOMICS!

Hello friends , I thought this article which published in "The economist " will clarify your doubts regarding the current financial crisis and will be able to reply some of doubts of the "jenious" on the economic theory failure on current financial crisis.




IN DEFENCE OF THE DISMAL SCIENCE

Aug 6th 2009





In a guest article, Robert Lucas, the John Dewey Distinguished Service

Professor of Economics at the University of Chicago, rebuts criticisms

that the financial crisis represents a failure of economics



THERE is widespread disappointment with economists now because we did

not forecast or prevent the financial crisis of 2008. THE ECONOMIST's

articles of July 18th on the state of economics were an interesting

attempt to take stock of two fields, macroeconomics[1] and financial

economics[2], but both pieces were dominated by the views of people who

have seized on the crisis as an opportunity to restate criticisms they

had voiced long before 2008. Macroeconomists in particular were

caricatured as a lost generation educated in the use of valueless, even

harmful, mathematical models, an education that made them incapable of

conducting sensible economic policy. I think this caricature is

nonsense and of no value in thinking about the larger questions: What

can the public reasonably expect of specialists in these areas, and how

well has it been served by them in the current crisis?



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 term "efficient"

as used here means that individuals use information in their own

private interest. It has nothing to do with socially desirable pricing;

people often confuse the two.)



Mr Fama arrived at the EMH through some simple theoretical examples.

This simplicity was criticised in THE ECONOMIST's briefing, as though

the EMH applied only to these hypothetical cases. But Mr Fama tested

the predictions of the EMH on the behaviour of actual prices. These

tests could have come out either way, but they came out very

favourably. His empirical work was novel and carefully executed. It has

been thoroughly challenged by a flood of criticism which has served

mainly to confirm the accuracy of the hypothesis. Over the years

exceptions and "anomalies" have been discovered (even tiny departures

are interesting if you are managing enough money) but for the purposes

of macroeconomic analysis and forecasting these departures 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.



THE ECONOMIST's briefing also cited as an example of macroeconomic

failure the "reassuring" simulations that Frederic Mishkin, then a

governor of the Federal Reserve, presented in the summer of 2007. The

charge is that the Fed's FRB/US forecasting model failed to predict the

events of September 2008. Yet the simulations were not presented as

assurance that no crisis would occur, but as a forecast of what could

be expected conditional on a crisis not occurring. Until the Lehman

failure the recession was pretty typical of the modest downturns of the

post-war period. There was a recession under way, led by the decline in

housing construction. Mr Mishkin's forecast was a reasonable estimate

of what would have followed if the housing decline had continued to be

the only or the main factor involved in the economic downturn. After

the Lehman bankruptcy, too, models very like the one Mr Mishkin had

used, combined with new information, gave what turned out to be very

accurate estimates of the private-spending reductions that ensued over

the next two quarters. When Ben Bernanke, the chairman of the Fed,

warned Hank Paulson, the then treasury secretary, of the economic

danger facing America immediately after Lehman's failure, he knew what

he was talking about.



Mr Mishkin recognised the potential for a financial crisis in 2007, of

course. Mr Bernanke certainly did as well. But recommending pre-emptive

monetary policies on the scale of the policies that were applied later

on would have been like turning abruptly off the road because of the

potential for someone suddenly to swerve head-on into your lane. The

best and only realistic thing you can do in this context is to keep

your eyes open and hope for the best.



After Lehman collapsed and the potential for crisis had become a

reality, the situation was completely altered. The interest on Treasury

bills was close to zero, and those who viewed interest-rate reductions

as the only stimulus available to the Fed thought that monetary policy

was now exhausted. But Mr Bernanke immediately switched gears, began

pumping cash into the banking system, and convinced the Treasury to do

the same. Commercial-bank reserves grew from $50 billion at the time of

the Lehman failure to something like $800 billion by the end of the

year. The injection of Troubled Asset Relief Programme funds added more

money to the financial system.



There is understandable controversy about many aspects of these actions

but they had the great advantages of speed and reversibility. My own

view, as expressed elsewhere, is that these policies were central to

relieving a fear-driven rush to liquidity and so alleviating (if only

partially) the perceived need for consumers and businesses to reduce

spending. The recession is now under control and no responsible

forecasters see anything remotely like the 1929-33 contraction in

America on the horizon. This outcome did not have to happen, but it did.



NOT BAD FOR A DARK AGE

Both Mr Bernanke and Mr Mishkin are in the mainstream of what one

critic cited in THE ECONOMIST's briefing calls a "Dark Age of

macroeconomics". They are exponents and creative builders of dynamic

models and have taught these "spectacularly useless" tools, directly

and through textbooks that have become industry standards, to

generations of students. Over the past two years they (and many other

accomplished macroeconomists) have been centrally involved in

responding to the most difficult American economic crisis since the

1930s. They have forecasted what can be forecast and formulated

contingency plans ready for use when unforeseeable shocks occurred.

They and their colleagues have drawn on recently developed theoretical

models when they judged them to have something to contribute. They have

drawn on the ideas and research of Keynes from the 1930s, of Friedman

and Schwartz in the 1960s, and of many others. I simply see no

connection between the reality of the macroeconomics that these people

represent and the caricature provided by the critics whose views

dominated THE ECONOMIST'S briefing.



THANKS,