One of the biggest public blunders in the history of economics was committed by Professor Irving Fisher a few days before the stock market crash of 1929, when he stated: “Stock prices have reached what looks like a permanently high plateau.” At the time, Fisher was probably the most famous economist in the US, a scholar who made lasting contributions to interest rate and monetary theory. Had a Nobel Prize in economics existed back then, he surely would have won it, such was his repute.
The Crash of 1929 effectively demolished Fisher’s outstanding academic career. He died largely forgotten in 1947, with the Keynesian revolutionaries already well entrenched in university faculties. This is more than sad, since in 1933 Fisher published one of the most brilliant analyses of the deep causes of the Great Depression in an article that is still well worth reading today.
Another not so good call was made in September 2007 by Professor Robert Lucas. While the signs became more and more clear that the US and by extension the rest of the World were sliding into a major financial crisis, he stated in an op-ed of the Wall Street Journal: “I am skeptical about the argument that the subprime mortgage problem will contaminate the whole mortgage market, that housing construction will come to a halt, and that the economy will slip into a recession […] If we have learned anything from the past 20 years it is that there is a lot of stability built into the real economy.”
Like Irving Fisher back in 1929, Robert Lucas is also one of the leading economists of his time with path-breaking contributions especially in business cycle and growth theory, which earned him the Nobel Prize in economics in 1995. His rational expectation revolution set itself as a task to put the macroeconomic theory, which was until then based upon ad hoc modeling, on sound rational bases. It actually drew the macroeconomic research agenda for the last thirty years.
No wonder that many economists, including the author, who studied during this period, feel now, after the financial crisis somewhat lost. Clearly the mathematically elegant models failed to forecast the financial crisis but this is not what is so bothering about them. Robert Lucas in a recent contribution to The Economist, correctly states: “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.”
What is really bothering though is that such models were obfuscating a far more complex reality. When Fed Chairman Ben Bernanke was still in 2005, just before the prices peaked, denying the existence of a housing bubble or when Fed Chairman Alan Greenspan explained back in 2002, that “it was very difficult to definitively indentify a bubble [in US equity markets] until after the fact”, they both built their judgment upon exactly those models.
If there is one lesson to be learned from the crisis, it is that those mainstream macroeconomic models are useless when it comes to exuberance or to deflate bubbles in the making. New, more farsighted models are needed.
Not everyone seems to agree here, though. In the same “The Economist” contribution, Professor Lucas stresses: “[…] the futility of trying to deal with crises and recessions by finding central bankers and regulators who can identify and puncture bubbles.” To err is human, but to persist is devilish.
