Frydman & Goldberg on Robert Lucas & F. A. Hayek

From Roman Frydman and Michael Goldberg’s new book Beyond Rational Markets: Asset Price Swings, Risk, and the Role of the State:

The problem that haunts the Rational Expectations Hypothesis is the same one that doomed socialist planning: no fully predetermined mechanism that drives market outcomes can, in principle, be uncovered. Basing the explanation of market outcomes on the decisionmaking of one individual who forecasts according to an economist’s Rational Expectations model ignores the division of knowledge, which, as Hayek (1945) pointed out, is what distinguishes resource allocation by decentralized markets from a so-called “optimal” deployment of by a single individual. Indeed, Lucas’s (1995, 2001) account of how the Rational Expectations Hypothesis led him to embrace the representative-agent construct stands in stark contrast to Hayek’s position.

In discussing market outcomes for a competitive industry, Lucas (2001, p. 13) argues that “one can show that an industry over time will operate so as to maximize a discounted, consumer surplus integral – a problem that is mathematically no harder than the present value maximizing problem faced by a single firm.” He then asks, “[W]ho, exactly, is solving his planning problem?” As Hayek did, he recognizes that the answer is “Adam Smith’s ‘invisible hand,’ of course, not an actual person” (Lucas, 2001, p. 13, emphasis added). Nevertheless,in a striking leap of faith, Lucas claims that an economist — that is, an actual person — can adequately represent what the invisible hand of the market does by solving he value-maximizing problem faced by a single firm.

For Hayek (1945 p. 520), the division of “knowledge which is not given to anyone in its totality” was the key to his argument that central planners could not, in principle, substitute for markets. In contrast, Lucas believes that because of Rational Expectations models rule out nonroutine change and the division of knowledge, they enable an economist to make use of single-agent optimization techniques, and thus are the right tools to comprehend market outcomes.

More later.

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