No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Eighteen: The “macro” view of the economy 465 GREAT ECONOMISTS IN HISTORY ROBERT LUCAS 1937-Present We’ve already had two great economists in this text that were pioneers in macroeconomics. Not surprisingly we had the originator, John Maynard Keynes (chapter 8) and the systematizer, Paul Samuelson (chapter 16). Our third great economist associated with macroeconomics, Robert Lucas, was awarded the Nobel Prize in Economic Sciences in 1995 for his work identifying some of the limitations of macroeconomics that preceded him. Specifically, he brought back in the human side of economics into the macroeconomic picture. Macroeconomists prior to Lucas believed that there was a tradeoff between inflation and unemployment (see chapter 17). If unemployment rose too high, it was possible to print more money and stimulate the economy to bring unemployment down. Yes, it would result in a higher inflation rate, but that was a tradeoff that policymakers could exploit. If inflation started gaining momentum, policymakers could do the reverse—tighten monetary policy and slow the economy, at the expense of a higher unemployment rate. This tradeoff was known as the Phillips curve, after British economist A.W. Phillips, who noticed this empirical relationship in his study of the U.K. from 1861-1957. Milton Friedman (our great economist from chapter 11) and Edmund Phelps had already attacked the idea that this relationship could be exploited, saying there was a short run tradeoff possible, but no long run tradeoff, as people’s expectations would adapt to the higher inflation reality. This made policy ineffective over the long term. Lucas took this logic even further. Using the new concept of Rational Expectations , Lucas argued that if people are rational, and they see the monetary authority printing money, it will not take them long to learn that this will lead to higher inflation, and they won’t be fooled into expanding production. People will come to understand the model that the Fed is using, and they will no longer behave according to the model’s assumptions. This more or less follows Lincoln’s Law: You can fool some of the people all the time, and you can fool all the people some of the time, but you can’t fool all the people all of the time. Eventually people will catch on to the Fed, and then policymakers won’t have any stable relationship to exploit. Lucas’ argument simply appealed to the standard microeconomic assumption of rational behavior—people acting in their own self-interest—but it had massive implications. In contrast to Friedman and Phelps, Lucas had individuals looking forward to ascertain what the future would hold. This suggested that policymakers could only succeed if they could fool people as to their actions. For Friedman and Phelps, policymakers could only be effective in the short run, not the long run. For Lucas, they could only be effective in the short run if they behaved unpredictably . Lucas further broadened this critique of policymaking to macroeconomic models more generally in 1976, in what is called the “Lucas Critique.” The large macroeconomic models that the Fed and others used were based on behaviors that would necessarily change over time. Any relationship that a policymaker would like to try to exploit would only be a stable if policymakers didn’t try to exploit it! As soon as they did, people would figure it out and it would no longer work. In a Lucas world, the economist as engineer would have a small role; the train is going to drive itself.