Unfortunately, in case it needs restating, freshwater economics turned out to be based on two ideas that aren’t true. The first (Fama) is that financial markets are efficient. The second (Lucas/Sargent/Wallace) is that the economy as a whole is a stable and self-correcting mechanism. The rational-expectations theorists didn’t refute Keynesianism: they assumed away the reason for its existence. Their models were based not just on rational expectations but on the additional assertion that markets clear more or less instantaneously. But were that true, there wouldn’t be any such thing as involuntary unemployment, or any need for counter-cyclical monetary policy.

John Cassidy