Posner on Lucas

Posner has an excellent post rebutting Lucas's article in the Economist. It is particularly interesting for his rebuttal of Lucas's revisionist history.

Lucas says in his article in the Economist that the Federal Reserve saved the day by pumping cash into the banking system and persuading the Treasury Department to do likewise. He does not mention the other measures taken by government. He praises Ben Bernanke, the chairman of the Fed, for having "formulated contingency plans ready for use when unforeseeable shocks occurred." In fact the Fed had no contingency plans for the housing and stock market shocks that rocked the economy. Its response when the shocks hit with full force last September was prompt, but also improvised and spasmodic--hence the failure to bail out Lehman Brothers, a failure that deepened the financial crisis by seizing up the commercial paper market.

The more important criticism that Posner makes is that Lucas, and Fama, so discounted the likelihood of asset bubbles that they ignored the consequences that they could have. The leap from efficient markets to no bubbles is a big leap.

The reason for the surprise was that leading macroeconomists and financial economists had believed until last September that there could never be another depression, that asset bubbles are a myth, that a recession can be more or less effortlessly averted by the Fed's reducing the federal funds rate, that the international banking industry was robust, and that our huge national debt was nothing to worry about, nor our very low personal savings rate. All these beliefs have turned out to be mistaken, along with extreme versions of the rational expectations hypothesis, the efficient-markets theory, and real business cycle theory.

The whole post is worth reading, as is Posner's book, A Failure of Capitalism, which I will comment on soon.