ROBERT LUCAS AND RATIONAL EXPECTATIONS

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An even bigger attack on Keynesianism came from Robert Lucas, the founder of a theory called rational expectations. (1) This highly mathematical theory dominated all economic thought in the 70s and early 80s, so much so that Lucas attracted a broad following of disciples who raised to him to cult-leader status. By 1982, Lucas' views were so entrenched that Edward Prescott of Carnegie-Mellon University would boast that his students had never heard Keynes' name.

Lucas won the Nobel Prize in 1995 for the core aspect of his theory, that rational businessmen adjust their behavior to the government's announced economic policies. However, history has not been kind to the rest of his theory. Lucas himself has abandoned work on rational expectations, devoting himself nowadays to other problems, like economic growth. His once broad following has dissipated. And Lucas himself would admit upon receiving his Nobel prize: "The Keynesian orthodoxy hasn't been replaced by anything yet." (2)

There are two main parts to rational expectations. First, Lucas began with the old assumption that recessions are self-correcting. Once people start hoarding money, it may take several quarters before everyone notices that a recession is occurring. That's because people recognize their own hardships first, but it may take awhile to realize that the same thing is happening to everyone else. Once they do recognize a general recession, however, their confusion clears, and the market quickly takes steps to recover. Producers will cut their prices to attract business, and workers will cut their wage demands to attract work. As prices deflate, the purchasing power of the dollar is strengthened, which has the same effect as increasing the money supply. Therefore, government should do nothing but wait the correction out.

Second, government intervention can only range from ineffectualness to harm. Suppose the Fed, looking at the leading economic indicators, learns that a recession has hit. But this information is also available to any businessman who reads a newspaper. Therefore, any government attempt to expand the money supply cannot happen before a businessman's decision to cut prices anyway. Keynesians are therefore robbed of the argument that perhaps the Fed might be useful in hastening a recovery, since Lucas showed that the Fed is not much faster than the market in discovering the problem.

Lucas then gave a fuller and more supported version of Milton Friedman's argument. Suppose the Fed established a predictable anti-recession policy: every time the unemployment rate climbs one percent, the Fed increases the money supply one percent. Rational businessmen would only come to expect these increases -- hence the term, rational expectations -- and would simply build automatic responses to monetary policy in their pricing systems. So in order to be effective, then, monetary policy would have to surprise businesses with random increases. But true randomness would make the economy less stable, not more so. The only logical conclusion is that the government's efforts to control the economy can be actually harmful.

Rational expectations borrowed heavily from earlier conservative theories, but Lucas supported these arguments mathematically, and in far greater detail and nuance. In fact, rational expectations spawned many new mathematical and statistical techniques, and allowed a generation of economists to specialize in these techniques. In a typical rational expectations model, the public adjusts its behavior to announced monetary policy. This is supposed to result in a more realistic description of the economy.

But despite its technical brilliance, today we know there are several major flaws in the theory.

First, it is not reasonable to believe that business owners generally determine their prices by following macroeconomic trends. Can you cite the Federal Reserve's rates and policies at the moment? The inflation and unemployment rates? The nation's GDP growth? Even more improbably, do you set your budget, prices and wage demands by these indicators? Only an economist (who knows all these statistics anyway) would think this is natural behavior.

Second, it is not reasonable to believe that humans are perfectly rational or perfectly informed. Much of Lucas' theory "worked" only after making such idealistic assumptions. Interestingly, Lucas and his followers have usually defended these assumptions by attacking their opposite. Early Keynesians had "overlooked" the fact that people would adjust their behavior to national economic policy. Here are some typical criticisms of this oversight by Lucas and others:

"The implicit presumption in these Keynesian models was that people could be fooled over and over again." -- Robert Lucas (3)

"The problem with the old models was that they assumed people were as dumb as dirt and could be fooled by the government into changing their behavior." -- Paul Romer (4)

"The essence of rational expectations could be summarized as 'people aren't as dense as policy makers used to think they were.'" -- Ron Ross (5)

The black and white universe of the Lucas school is rather amusing: if human beings are not walking calculators or walking statistics manuals, then, by God, Keynesians must think they are complete idiots. The truth is a bit more prosaic. Keynesians have primarily based their theories on historical evidence, not assumptions of citizen ignorance. Money has never deflated easily, for whatever reason, and Keynesian policies seem to work best in smoothing out the business cycle. The failure to deflate may spring from many sources: not just citizen ignorance of monetary policy, but certainly price rigidities as well. For example, during the severe recession of 1982, the Fed's proposal to expand the money supply was widely debated in the press. When the Fed did move, it was well announced. But rational and expectant businessmen did not raise their prices and create inflation. On the contrary, 1983 actually saw lower inflation, as well as a job-creation boom that would last seven years.

And this leads to the third flaw: Lucas's theory just doesn't explain reality very well. In an article entitled "Great Theory… As Far as it Goes," economist Michael Mandel writes: "Unfortunately, models built on rational expectations do not reflect the real world as well as the old Keynesian models they were supposed to replace… Most economic forecasting models still have a Keynesian core." (6)

To wit, the recessions of 80-82 and 90-92 behaved very differently from what Lucas's models predicted. Keep in mind their key assertion that recessions only happen because individuals are temporarily confused about the situation. Once workers realize they are in a general recession, they will cut their wage demands, which will restore full employment. But after the unemployment rate hit 10.7 percent in the winter of 1982, it took until 1987 for it to recover to 1979 levels (about 5-6 percent). Did it really take workers eight years to figure out they were in a recession before cutting their wage demands by the necessary amount? Of course not.

The main obstacle to Lucas's theory is that that recessions last far too long to attribute them to temporary public confusion about the situation. Jimmy Carter was voted out of office for a "misery index" (inflation plus unemployment) that crested 20 percent. Yet it wasn't until the second year of Reagan's term that a recovery started. The same with George Bush -- a recession struck in 1990, and his 90 percent approval rating took a free fall in the election campaign that followed. That campaign was defined by James Carville's slogan, "It's the economy, stupid." The economy did not truly start recovering until 1992, and employment took even longer to recover. If the public's awareness of recessions is great enough to drive presidents out of office after extended campaigns, it's clear that people understand their plight. But then why do recessions last so long?

Lucas and his followers searched everywhere for a model that would keep businessmen aware of leading economic indicators and yet ignorant of the fact that they were in a recession. Needless to say, they did not find one.

Life after Lucas

Around the mid-80s, economists became aware of the theory's shortcomings. One of these was probably Lucas himself, who never really bothered to defend it when journals began seriously questioning it. As Lucas moved on to other projects, conservatives economists found themselves back at the drawing board, asking themselves such basic questions as: what is a recession?

The existence of recessions has always been an embarrassment to economists on the right. Recessions suggest that markets are not magical, that they often result in hardship and suffering. One far-right tack, as exemplified by the Austrian School of Economics, is to blame them on government. But depressions were exclusively a feature of laissez-faire economies; since the rise of modern welfare states, nations have seen greatly reduced recessions and unprecedented economic growth. So much for the government scapegoat.

The opposite tack, as exemplified by "real business cycle theory," has been to claim that recessions are actually beneficial self-cleansing rituals of the market. Thanks to recessions, the market adapts to change. This idea has been satirized in such Keynesian articles as Willem Buiter's "The Economics of Doctor Pangloss," after Voltaire's fictional philosopher who believes everything is for the best. As Paul Krugman remarked: "If recessions are a rational response to temporary setbacks in productivity, was the Great Depression really just an extended, voluntary holiday?" (7)

Real business cycle theory was presented as a replacement to rational expectations, but it ended up imploding under self-criticism and ideological infighting. Unlike monetarism or rational expectations, it never became a serious movement.

Instead, economics has seen the revival of Keynes, with the emergence of New Keynesianism. Many people thought that Lucas had refuted Keynesianism as a matter of principle. Any businessman with a newspaper would learn of a recession as quickly as the Fed, and would nullify the Fed's actions with the appropriate counteractions. However, economist George Akerlof would undermine this "refutation" with his own seminal article, "The Market for Lemons." Akerlof made two crucial observations, one of them obvious, one of them not-so-obvious.

The obvious one was that human beings are nearly rational, not perfectly rational. The not-so-obvious one is that nearly rational people may make decisions that approximate those of perfectly rational people, yet still obtain completely different economic results. Two examples best illustrate this point:

Suppose a farmer is selling wheat on the market, and notices that demand drops. Every other farmer is selling wheat for five cents a bushel less than he is. Now, wheat is a homogenous product, meaning that one farmer's wheat is virtually identical to another farmer's wheat. There is no advantage for a buyer to buy wheat at a higher price, so it would be foolish for the farmer to stay a nickel above the competition. The farmer may not want to lower his prices, but the market's supply and demand will force him to. So although the farmer is only nearly rational, he can come to perfectly rational decisions when the product is a homogenous one.

But what if the product is not homegenous? What if you're selling artwork? Artwork can range from a first-grader's finger-painting to "Ambroise Vollard" by Picasso. You might have a general idea of what's it worth, but to figure it to the penny, like wheat, is impossible. Too many variables affect the final price. One art collector might want the Picasso more than another collector, and be willing to pay more for it during an auction. A movie or book about Picasso might spur unusual interest in his paintings over those of Monet. A rich idiot might come along who has no idea what it's really worth. Therefore, an art seller is not being irrational by refusing to sell it to someone in the hopes of gaining a higher price. In other words, there is a range of acceptable prices, and most people hold out for higher prices out of self-interest.

The vast majority of goods on the market are not homogenous: examples include cars, homes, even workers on the labor market. People may be fully aware of a recession when they are in one, but they do not know how much they should reduce their prices. To know the exact percentage would require an astronomical amount of information and calculating ability. The cost of arriving at such a calculation would surely outweigh its benefits. Therefore, people should -- as a matter of principle -- try to make best guesses. Unfortunately, this often results in the sort of price stickiness that prevents recessions from curing themselves. Keynesian policies therefore remain a useful tool in cutting recessions short. We have long known that this is so in practice; it's heartening to know that this is so in theory now as well.