A little more than two weeks ago, Nobel prize-winning economist, Robert Lucas Jr., passed away. This news compounded the loss the profession faced in the death of intellectual fellow-traveler Edward Prescott in December.
In previous articles, I have argued that there should be no Nobel prize in economics. I still believe this. However, I’m able to recognize that given there is a Nobel prize in economics, the people who receive the prize are important signals of the thinking of the profession.
Robert Lucas was a good economist, and a good signal for the profession. His contributions were many, but I will focus on perhaps his most famous— the Lucas Critique.
The Economic ‘Experts’
To understand the importance of the Lucas critique, it’s valuable to travel back in time a bit to the 1960s. In the 60s, the dominant paradigm in thinking about the economy as a whole (macroeconomics) was the Keynesian paradigm.
Issues with Keynesian economics are many, but the major idea of interest was Keynesian economists’ adoption of the belief that there is a tradeoff between inflation and unemployment. In other words, when inflation goes up, unemployment goes down and vice versa.
Economists call this apparent tradeoff the Phillips curve. One important note is that John Maynard Keynes himself did not pioneer the idea of the Phillips curve, but his intellectual heirs at the time believed it naturally fell out of his basic macroeconomic framework. In the words of economist Alan Blinder.
“Prior to 1970, Keynesians believed that the long-run level of unemployment depended on government policy, and that the government could achieve a low unemployment rate by accepting a high but steady rate of inflation.”
When the 60s arrived, Keynesians had a chance to test their theory. From 1958 to 1962, unemployment hovered between 5.5% and 7%. In other words, unemployment was high. The Keynesian response, then, was to adopt a monetary policy that increased inflation. Money printing means more spending which means more jobs a la the Phillips curve.
So what was the result? Well things worked at first. Look at this graph showing inflation and unemployment.
Figure 1—Inflation and Unemployment in the 1960s
As you can see, as inflation increased the unemployment rate fell. This is exactly what Keynesians predicted with the Phillips curve. But there was a problem. This didn’t last forever. Look what happened in the 1970s.
Figure 2—Inflation and Unemployment in the 1970s
Notice, by 1980 both inflation and unemployment increased! In other words, there was no longer any tradeoff. The Keynesian rules of macroeconomics broke down before the eyes of everyone. Something was wrong with “expert” thinking.
To understand what happened, we first have to think a little bit about how the Phillips curve was supposed to work. Essentially, when inflation started to increase and prices rose, this would mean job postings would be offering what looked like higher wages.
If everything becomes 10x more expensive, including labor, suddenly a $3 an hour job would become a $30 an hour job. Well, to people not yet used to higher prices, a $3 an hour job may sound bad, but a $30 an hour job may sound much better. In other words, higher nominal wages tricked workers into taking jobs they otherwise wouldn’t.
The logic of using the Phillips curve in policy relies on the idea that policy-makers can trick ordinary people into behaving the way they want.
The Lucas Critique
The Lucas Critique aimed directly at activist policy like the use of the Phillips curve in the 60s and 70s. Essentially Robert Lucas argued that policy-makers cannot assume that citizens will be repeatedly tricked into making the same mistake.
Keynesian policy at the time assumed that the experts, over the long run, would have more knowledge and information than ordinary people. Lucas flipped this thinking on its head. Why not assume that smart and creative people will be able to grasp the basic concepts of macroeconomic models, and update their expectations based on that understanding?
In other words, in the 1970s people began to realize the jobs they had taken were not actually the high-paying jobs they believed they were. They had been “tricked” into accepting the jobs by inflation. But no more. People knew that 6% inflation meant their real wages were 6% lower.
In order to lower unemployment again, the monetary authority would have to increase inflation even more than people expected. This is why you see the Phillips curve moving right in the 70s. Higher and higher rates of inflation were needed to fool people. And by 1980, not even a nearly 13% rate of inflation could trick people. Unemployment held high and steady at 7%.
The Keynesian thinking of the time assumed the policy-makers were experts outside of the model of the economy, and they could adjust certain parameters of the model (like the inflation rate) to influence other models (like unemployment).
But as the Lucas critique points out, people are not simply chess pieces responding to the parameters enlightened experts tweak. Instead, people are intelligent and responsive. You cannot expect people to respond the same way to changes each time.
Unlike the natural sciences, the subjects of the social sciences (human beings) think and react differently. They themselves can learn the policy-makers’ game and beat them at it.
The Lucas Critique is not merely about the historical moment of the Phillips curve. Any macroeconomic model which assumes people will not adapt to the implementation of policies is called into question in the Lucas critique.
The standard of Robert Lucas forces economists to think of economic actors as rational and responsive. Any policy that assumes consistent stupidity on the part of people can (and should) be called into question.
Robert Lucas was a beacon of humility in the profession. His work forces economists to put people, creative and ambitious, back into macroeconomic conversations. As such, despite my dislike of the economics Nobel prize, I can say without reservation that Robert Lucas deserved his. Rest in peace.
The post Why the Late Robert Lucas Deserved His Nobel Prize was first published by the Foundation for Economic Education, and is republished here with permission. Please support their efforts.