Last week, Robert Lucas, the winner of the1995 Nobel Prize in economics, passed away at age 85. Although he wasn’t a household name like John Maynard Keynes or Milton Friedman, Lucas transformed the field of macroeconomics. His insights led Harvard economist and popular textbook writer Gregory Mankiw to write that Lucas was “the most influential macroeconomist of the last quarter of the 20th century.” While Lucas contributed many crucial ideas and models to the field, he is most famous for his work on rational expectations in business cycles and in long-run economic growth.
Rational Expectations and the ‘Lucas Critique’
Along with other economists, including fellow future Nobel Prize winners Thomas Sargent and Edward Prescott, Lucas led the “rational expectations revolution” of the 1970s. The theory of rational expectations posits that individuals use all available information in making predictions about the future, which means their predictions will change as they learn. This assumption has critical implications for many areas of public policy, and it led to the overturning of the then-prevailing “Old Keynesian” school of macroeconomics.
By the 1960s and 1970s, many Keynesian economists believed in a crude version of the Phillips Curve, which states that there is a tradeoff between unemployment and inflation. If unemployment is too high, the government can use monetary policy to stimulate demand in the economy and bring unemployment down. A more expansionary monetary policy lowers borrowing costs, and more money ends up in the hands of workers and companies. This leads to a “tight” labor market, where more people are employed and can spend their money on goods and services. Employers must offer higher wages to compete for workers. Inflation would then rise. Similarly, if inflation is too high, the government can bring it down at the cost of higher unemployment.
During the 1970s, however, the U.S. and several other developed economies experienced “stagflation,” a combination of both high unemployment and high inflation. The Keynesian school failed to explain this phenomenon. Building on earlier arguments by Milton Friedman and Edmund Phelps, Lucas explained that the Phillips Curve was flawed because it failed to consider people’s changing predictions as new information emerged. If inflation rises by surprise, it can temporarily reduce unemployment.
However, if the government tries repeatedly to stimulate the economy to reduce unemployment at the cost of higher inflation, the public will realize what the government is trying to do. Businesses will set higher prices and workers will demand higher wages in anticipation of higher inflation. Trying to stimulate demand to bring unemployment down will only lead to higher inflation in the long run. This theory of rational expectations calls to mind Abraham Lincoln’s maxim, “You can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time.” Although members of the public do not always forecast accurately, the government cannot systematically fool the entire public for some desired end.
Lucas’ work on rational expectations led to a related concept called the “Lucas Critique”: Policymakers cannot predict the effects of a change in policy simply by looking at previously observed data. Rather, they must consider how the change in policy will affect people’s expectations. While reliance on the Phillips Curve is probably the most-used example of failing to address the Lucas Critique, there are many instances where the critique is relevant, and not just in traditional macroeconomics or finance.
Another example economists like to cite is security at Fort Knox, which serves as a military base and stores much of the U.S. gold reserves. Fort Knox is heavily guarded, but it has also never been robbed. A naïve observer may conclude that Fort Knox does not need security because it has never been robbed, and eliminating security would save taxpayer money. However, this analysis fails to take into account that criminals likely don’t attempt to rob Fort Knox precisely because of its security.
Lucas’ work on rational expectations led to a rewriting of mainstream macroeconomic models. The “Old Keynesian” model was replaced by the “New Keynesian” model, in which all economic agents (companies, households, etc.) are forward-looking and have rational expectations about the future. The Phillips Curve was also modified to show that only surprise inflation matters for affecting unemployment. The New Keynesian model has become the dominant framework in macroeconomics today. While Lucas had some disagreements with this approach, too, there is no question that his work was critical in its development.
Economic Growth and Development
While Lucas won the Nobel Prize for his work on rational expectations and how they related to business cycles, he later realized that boosting long-run growth is much more important to people’s living standards than mitigating short-run booms and busts. For example, the figure below shows U.S. inflation-adjusted GDP per capita from 1800 to 2018.
The figure shows some ups and downs, but they generally appear to be mere blips as the series trends upward. This is not to say that people don’t suffer during downturns. For example, during the Great Depression years of 1929 to 1939, people’s income fell nearly 7%. For certain years in that timeframe, unemployment also peaked at more than 25%. Nevertheless, this downturn is very small in comparison to the longer period from 1929 to 2018, when income grew more than 350%.
Lucas further understood that poor countries stand to gain the most from policies that boost long-run growth. Famously, in a 1988 paper he observed the diversity in growth rates across countries. At that time, India grew only around 1.4% per year, while South Korea grew 7% per year. Lucas calculated that at those rates “[a]n Indian will, on average, be twice as well off as his grandfather; a Korean 32 times.” This led him to write:
Is there some action a government of India could take that would lead the Indian economy to grow like Indonesia’s or Egypt’s? If so, what, exactly? If not, what is it about the ‘nature of India’ that makes it so? The consequences for human welfare involved in questions like these are simply staggering: Once one starts to think about them, it is hard to think about anything else.
Later, in 1990, Lucas asked another question: “Why doesn’t capital flow from rich to poor countries?” Capital makes workers more productive. Since there are diminishing returns to any investment, then capital should flow from rich countries to poor countries, where there should be greater potential returns. However, Lucas observed this is frequently not the case for two main reasons.
First, poor countries have comparatively less human capital (formal education and job training) to attract investment. Second, international capital markets are “imperfect.” There is a risk that poor countries could renege on promises to pay back loans. Investors may also be reluctant to invest in countries where they cannot easily monitor their investments. With this in mind, policymakers should aim to increase human capital in poor countries and tie foreign aid to recipients’ openness to foreign investment on “competitive terms” (terms where lenders can feel safe that they will get their money back).
‘We Are Basically Storytellers’
As National Review’s Dominic Pino points out, if you have to read one piece by Lucas, read his short six-page lecture “What Economists Do,” where he remarked that economists are storytellers. Lucas then compared an amusement park to the U.S. economy, where amusement park tickets are money, and rides and concessions are goods and services. By manipulating the exchange rate for dollars to park tickets, he could cause the park’s economy to boom or bust. For example, suppose that 10 tickets initially cost $1.00. Then one morning, without warning, the price of tickets rises, so $1.00 buys only 8 tickets. Customers will likely be disappointed if not angry at the news. Some customers may turn around and go home. Others will buy fewer tickets. With fewer tickets purchased, the park’s money supply shrinks, and fewer people will spend money on rides and concessions. Thus, the park’s economy shrinks, too.
Lucas concludes that economists spend much of their time “in worlds of make believe.” However, this is not because they are trying to escape reality. Rather, the realm of imagination and ideas “is the only way . . . to think seriously about reality.”
Robert Lucas was someone whose imagination and ideas caused a sea change in understanding macroeconomics and public policy. Not all macroeconomists agree with Lucas’ theories and normative conclusions for public policy today, but they all must grapple with his insights and what they mean for their own models of the real world.