Economics fails to resolve exceptions to the rule


As the financial crisis continues to evolve, the Queen’s question at the London School of Economics – why have academic economists so little to contribute to predicting the course of events – continues to be all too pertinent.

Robert Lucas, professor of economics at the University of Chicago and Nobel Prize winner for his seminal contributions to macroeconomics, proffered an answer in 2009. The crisis was not predicted, he explained, because economic theory predicts that such events cannot be predicted. Faced with that response, a wise sovereign will seek counsel elsewhere.

Still, Prof Lucas’s assertion that “no one could have predicted it” contains an important insight. There can be no objective basis for a prediction of the kind “Lehman Bros will go into liquidation on September 15”, because if there were, people would act on that expectation and Lehman would go into liquidation straight away. The economic world, far more than the physical world, is influenced by our beliefs about it.

Such reflexivity leads to the efficient market hypothesis, which claims that available knowledge is already incorporated in the price of securities. The hypothesis is substantially true. The growth prospects of Apple and Google, the problems of Greece and the eurozone, are reflected in the prices of shares, bonds and currencies. It is a mistake to ignore the efficient market hypothesis; it is also a mistake to take it too seriously. Market prices incorporate much information, but not necessarily accurately, or completely. There are usually wide and persistent differences in beliefs, and different perceptions of an uncertain future.

Prof Lucas acknowledges that “exceptions and anomalies” to the efficient market hypothesis have been discovered, “but for the purposes of macroeconomic analyses and forecasts they are too small to matter”. This is a puzzling remark. How could anyone know, in advance of any future crisis, that exceptions and anomalies to the EMH are “too small to matter”?

A complex piece of machinery like an oil rig or a nuclear reactor sometimes malfunctions. It can do so even though almost all elements operate as intended. A few failed components may bring about collapse in a complex interdependent system. As in the Gulf of Mexico spill, or at the Fukushima disaster, or in the credit market in 2008.

I think Prof Lucas means that attempts to construct general models of exceptions to the efficient market hypothesis have enjoyed little success. There can be no method that systematically identifies departures from EMH because, if there were, people would act on that knowledge, and the observations would cease to be anomalies or exceptions. But to conclude that there is no general model of exceptions and anomalies in the EMH is not the same as saying that such exceptions and anomalies do not exist.

The behaviour of great industrialists such as Henry Ford or Steve Jobs, or great investors such as Warren Buffett and George Soros, cannot be predicted by general rules. If such prediction were possible, their actions would have been anticipated and these individuals would not have been innovative or become rich. And similar unpredictability applies to the actions of great fools, such as those who believed that securitisation conjured immense wealth out of thin air. Like ingenuity, stupidity endures but constantly finds new ways to express itself.

The economic impact of those who see profit opportunities others have missed is plainly not “too small to matter”. Such actions have not only made individuals rich, but changed the world in ways that proponents of the EMH could not have imagined because they had ruled them out a priori. Prof Lucas claims that “if your theory reveals profit opportunities, you have the wrong theory”. This sounds like the response of the idiot savant.

Profit opportunities are not easy to come by, but the search for such opportunities drives markets. Nothing could be stranger – or more deeply irrelevant – than a model of the market economy whose axioms exclude its central dynamic.

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