A titan in the field of economics, Robert Emerson Lucas Jr (known to his devotees as "Bob") passed away on May 15 in Chicago. He was 85. Bob Lucas was awarded the Nobel Prize in Economics in 1995 for his seminal contribution to macroeconomic theory. During his rich and very productive career, Lucas served as a professor of Economics at the University of Chicago and is best known for his path-breaking work on the "rational expectations" concept, which revolutionised economic policymaking. The Swedish Royal Academy of Sciences cited him as "the economist who has had the greatest influence on macroeconomic research since 1970."
One of the joys of being an economist is participating in the ritual that surrounds the announcement of the Nobel Prize in Economics towards the end of each year. You learn about new developments in the field and reconnect with the economic theories and economists you have known since your graduate school days. However, there is a downside. Economists whom you've admired since your youthful days leave this world, and then you spend a few days reflecting on their work and how it affected your life.
So many memories come to my mind as I write this tribute and grieve the passing of Bob Lucas.
When I was a graduate student in the US and was cramming up Keynesian models and policy prescriptions, we learned about the Phillips curve model, which showed that government spending could lower the unemployment rate. However, in real life, it was emerging that government intervention does not necessarily get the economy out of a rut. Why? Well, if there is no excess capacity, or the consumers expect higher price levels, government spending will only lead to inflation. The term stagflation became fashionable in the 70s and 80s, and baffled economists.
Bob Lucas became a household name as economists struggled to find a way to get out of stagflation. Until the 1970s, governments were guided by the policies popularised by John Maynard Keynes. But the high inflation and high unemployment that characterised much of the 1970s simply could not exist concomitantly in Keynes' world, and the Chicago School, led by Milton Friedman, challenged the Keynesian framework.
Bob was a student of Friedman, another Nobel laureate, who paraphrased Abraham Lincoln in explaining his position on monetary policy: "You can fool all of the people some of the time, and some of the people all of the time. But you can't fool all of the people all of the time." A central bank can have an occasional impact on the level of economic activity by controlling interest rates. But if this power is used too often, firms and households will adjust expectations of price changes and neutralise any impact on real activity. That is the core of monetarism and the basis for the rational expectations theory.
To understand how rational expectations changed our understanding of markets, economic behaviour, and economic policy, let us consider the well-known "cobweb theorem", which generations of economists have memorised in their undergraduate years. The model assumes that farmers decide on next year's (or Year One) supply decisions on the basis of the previous year's (Year Zero) price, which they presume will remain the same. Assume now that Year Zero's price was high and farmers expect the price in Year One to stay high and plant more acreage and produce more; this will flood the market and lower the price! Consequently, the following year (Year Two), there will be a cutback – reducing production – and this will increase the price again, leading to the perpetual upward and downward cycle (or, disequilibrium).
A US-American economist named John Muth challenged the assumption that farmers expect Year One price to be the same as that in Year Zero. He proposed that farmers learn from the past and make their decisions based on forward-looking expectations. He used the term "rational expectations" to describe the many economic situations in which the outcome depends partly on what people expect will happen. As another example, the value of a currency and its rate of depreciation depend partly on what people expect that depreciation rate to be. That is because people rush to desert a currency that they expect to lose value, thereby contributing to its loss in value. Similarly, the price of a stock or bond depends partly on what prospective buyers and sellers believe it will be in the future.
Lucas picked up on this idea and questioned the theories of Keynes, who had pushed the policy prescription that government intervention could help steer the economy. Lucas' work on rational expectations in macroeconomics transformed the thinking surrounding the relationship between inflation and unemployment, pointing to the ineffectiveness of policy in the long run, despite possible short-run impacts on unemployment.
The eponymous "Lucas critique" also pointed out that it is naive to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, particularly aggregate data. People are smart and make their decisions by taking into account all available information, including future price expectations.
"Anything that happens in the economy happens because people do this or that or something else," Lucas wrote. "If we're trying to understand that, we have to get inside those people and ask what they're thinking. The rational expectations answer is they're thinking what they should be thinking. If they're making a forecast they're probably doing it well. People know their own business better than outsiders like economists do and we want to try and get into that."
