In 2003, Nobel laureate Robert Lucas wrote admiringly in his Presidential address for the American Economic Association that the field of economics was itself a put-forward solution to the Great Depression. Such was the calamity that enormous intellectual effort was expanded so as to never repeat it. Though with that belated task there is also, or there at least should be, caution about the dangers of insufficient knowledge. If we are to take Lucas’s history as fact, then can we conclude anything other than economists prior to it were ineffective, insouciant, and ignorant?
Macroeconomics was born as a distinct field in the 1940s, as a part of the intellectual response to the Great Depression. The term then referred to the body of knowledge and expertise that we hoped would prevent the recurrence of that economic disaster. My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades.
The central innovation, if it may be called that, was his own: rational expectations theory. There is no other way to state it, but rational expectations is a mathematical solution to a problem of infinities. It simply does not exist in the real world, for how can it? To describe it in layman’s terms is to reveal the dodge: economists model consumer and individual behavior as if every single one of us is either himself a social scientist in the same mold, or at the very least has one on retainer so as to consult with for every single economic and financial decision.
The problem is knowledge and the future. We simply cannot know it, and even if we could there is still the non-trivial problem of trying to understand it. In a 2013 Bloomberg interview taken with also Nobel laureate Edmund Phelps, Phelps touched on this glaring inconsistency:
You’re right that people are grossly uninformed, which is a far cry from what the rational expectations models suppose. Why are they misinformed? I think they don’t pay much attention to the vast information out there because they wouldn’t know what to do what to do [sic] with it if they had it. The fundamental fallacy on which rational expectations models are based is that everyone knows how to process the information they receive according to the one and only right theory of the world.
People do act in that manner, if via shortcuts. In the hedge fund business there is, or was, something called the hedge fund “hotelâ€, where a few “leaders†would be relentlessly copied down to the last possible trade each and every time their 13F was updated (an actual hedge fund hotel is the modern version of the brassplate office). In other markets, including stocks, Alan Greenspan became just this kind of central shorthand for not bothering to understand a good deal of vital information. During the dot-com boom, it was typical to hear managers and especially economists play down every single concern with some variation of “Greenspan will get it right.â€
