Do Chicago Economics Nobel-Prize Winners Live in the Consensus Reality?
links for 2009-09-28

Are Chicago Economics Nobel-Prize Winners von Neumann-Morgenstern Agents?

Something old. On March 30, 2009 Tom Keene of Bloomberg's "On the Economy" interviewed Robert Lucas and Edward Prescott.

There is one really interesting juxtaposition from Lucas's part of the interview:

LUCAS: Our economy’s got a remarkable ability to return to its long term growth trend. And for most of the depressions we’ve had or recessions, the return has been quick. Two or three, four years...


LUCAS: [T]here is no question that fear is what this liquidity crisis is. I mean the reason I got into money [with my portfolio] is that I got afraid to leave my pension fund in other securities. So I’m sitting there with a portfolio full of zero-yield stuff just because I’m afraid to do anything else. I think there are millions of people like me.

KEENE: What will be the signal for Robert Lucas to go back into the markets...?

LUCAS: I don’t know. Robert Rubin made a joke about that in the first session today. Nobody knows...

Let's parse this. First, Robert Lucas says that it is highly likely--certainly his median forecast--that the U.S. economy will be back to normal in three or four years, with a normal level of unemployment, a normal share of profits in national income, and a normal level of dividends and capital gains. This presumably means that stock prices will also be back to normal--a normal multiple of a ten-year moving average of lagged earnings, for example. That means a year-2013 S&P of 2000 or so, compared to its current value of 1044 or its 2009 low of 667. Investing in the S&P 500 for a four-year horizon now is risky, certainly, but the expected return is high. And holding your money in cash is not all that safe either: most of the scenarios I can envision in which the S&P 500 is at a real value in 2013 corresponding to today's 667 are scenarios in which inflation has eaten away most of the value of cash.

So what is Robert Lucas doing holding his entire portfolio in cash? Has risk suddenly increased to an extraordinary extent to force the equity share of his portfolio down from 70% to 0% while his expected four-year return on equities over Treasuries has gone from 2.5% or so to 20%? Has his personal tolerance for risk suddenly collapsed to such an extent because he has become a complete coward? Or does he no longer believe his forecast that the U.S. economy is highly likely to be back to normal in four years? Or is he simply not a von Neumann-Morgenstern agent, and moreover lacks any desire to behave as if he were one?

No von Neumann-Morgenstern agent faced with such returns would hold his entire TIAA-CREF portfolio in cash. Not a one.

Now let me back up a little to Lucas's attack on Robert Shiller and George Akerlof, and their book Animal Spirits:

LUCAS: I just don’t get it. I mean look at the Black_Scholes formula. People come up with a formula for pricing options, just out of purely mathematical reasoning, and then it turns out it fits certain data amazingly well. And it’s been incredibly useful to people. Now it’s not useful for everything, but for what it does it’s a huge advance in human knowledge. Now what’s the behavioral finance contribution? They reinforce the idea of skepticism. Well, skepticism, it’s easy to be a skeptic. What’s harder is to tell somebody how to do something they didn’t know how to do yesterday. That’s what Black and Scholes did...

Lucas seems to miss the entire big point. Black-Scholes tells you how to do things only if the trades of the non-von Neumann-Morgenstern agents in the economy--that's you, Bob--cancel each other out. If they don't cancel each other out--if there are, as you say, "millions of people like me," then a whole bunch of banks running off of Black-Scholes and similar models without taking account of your existence are going to create a hell of a lot of systemic risk, and then 10% unemployment.