Lucas Economics Needs a Scientific Revolution
Nobel laureate economist Robert Lucas passed away a few days ago. He is said to be one of the most influential economist of the last 50 years.
It would be inappropriate and wrong to criticize the man, who seems to have been a truly great person, who for example continued mentoring students long after retiring.
But, I think that there is no need for a grieving period before his ideas can be scrutinized.
As far as I am concerned, I think the whole “rational expectation” dogma has driven economics into a rut. After years of observing market participants, I am convinced that the fraction of truly rational people is extremely small, clearly not enough to base a theory on. And don’t tell me that we can nevertheless treat economic agents “as if” they were rational!
Even clever people can’t help making stupid mistakes!
Edvard Munch. 1893. The Scream. Oil, tempera and pastel on cardboard. 91 x 73 cm. National Gallery of Norway.
As a result of behavioral biases that we all suffer from, and also because of herd spirits that lead us to do things only because other people do it, even when we feel deep inside that it is folly to do so. Crowd phenomena are a thing, and, to my mind, are the main determinant of economic crises and financial crashes (in the absence of exogenous shocks, with 2008 as a case in point). Crowds can be rational even when individuals are not (this is M. Friedman’s “as if” credo) but, more importantly, crowds can be irrational even when individuals are not. This is one of the most worrying blind spot of Lucas’s paradigm.
Another argument is: “people may not be rational, but they learn to be”. But our world is no simple game: its dynamics is complex, non-ergodic, non-stationary. Patterns do not necessarily repeat. We learn the past, but how useful is it in the face of radical uncertainty? And even when individual learn (a little) they eventually die and the new generation, alas, forgot the lessons of the past. The famous Lucas critique would apply if our task was to learn to play tic-tac-toe, but is irrelevant for us humans with limited cognitive capacities and overwhelming emotions.
Lucas declared in 2009 that “The 2008 crisis was not predicted because economic theory predicts that such events cannot be predicted”.
When you are convinced (or pretend to be so) that economic agents are rational, this is correct: crises can only be exogenous.
I rather believe that economic theory, as embodied by Lucas, is deeply flawed and that we can (collectively) do much better. Not that crises may ever be exactly timed, but at least the mechanisms leading to economic instabilities can be mapped out. Imagine a geophysicist saying: “The Kobe earthquake was not predicted because physics predicts that such events cannot be predicted”. We would rightly tell him: it’s because you don’t understand the mechanisms well enough! Measure more things! Make realistic models! Use numerical simulations! How could we accept such a grotesque statement?
Lucas economics (still) needs a scientific revolution!
Written by:
Professor Jean-Philippe Bouchaud
