What Lucas means when he asserts that deviations are ‘too small to matter’ is that attempts to construct general models of deviations from the efficient market hypothesis – by specifying mechanical trading rules or by writing equations to identify bubbles in asset prices – have not met with much success. But this is to miss the point: the expert billiard player plays a nearly perfect game, but it is the imperfections of play between experts that determine the result. There is a – trivial – sense in which the deviations from efficient markets are too small to matter – and a more important sense in which these deviations are the principal thing that matters.”
Mostly agreeing with Kay, Paul Krugman repeats a point he has made before about the freshwater economists — their failure to understand the deductive implications of their own models:
Here’s what we agree on: if consumers have perfect foresight, live forever, have perfect access to capital markets, etc., then they will take into account the expected future burden of taxes to pay for government spending. If the government introduces a new program that will spend $100 billion a year forever, then taxes must ultimately go up by the present-value equivalent of $100 billion forever. Assume that consumers want to reduce consumption by the same amount every year to offset this tax burden; then consumer spending will fall by $100 billion per year to compensate, wiping out any expansionary effect of the government spending.
But suppose that the increase in government spending is temporary, not permanent — that it will increase spending by $100 billion per year for only 1 or 2 years, not forever. This clearly implies a lower future tax burden than $100 billion a year forever, and therefore implies a fall in consumer spending of less than $100 billion per year. So the spending program IS expansionary in this case, EVEN IF you have full Ricardian equivalence.”
As Krugman says:
The fact that these guys don’t even get the implications of their own models right tells us that the problem runs deeper than believing too much in abstract math. At some level it has to be political: they want to declare government policy ineffectual so badly that for all their vaunted modeling mojo they can’t be bothered to think it through, or listen to other people who point out their error.”