The Long FAQ on Liberalism
A Critique of the Chicago School of Economics:
ROBERT LUCAS AND RATIONAL EXPECTATIONS
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his Nobel prize: "The Keynesian orthodoxy hasn't been replaced
by anything yet."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
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
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.
"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)
And this leads to the third flaw: Lucas's theory just doesn't
explain reality very well. In an article entitled "Great
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?"
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
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.
Next Section: Ronald Coase and the Coase Theorem
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1. Unless otherwise noted, this essay is primarily based on Paul
Krugman, Peddling Prosperity (New York: W.W. Norton &
Company, 1994), pp. 47-53, 197-205.
2. Steven Pearlstein, "Chicago Economist Wins Nobel Prize:
Lucas has Focused on Theoretical Issues," San Jose Mercury
News, Wednesday, October 11, 1995, p. 4A.
3. "Economics dynasty continues: Robert Lucas wins Nobel
Prize," Chicago Journal, The University of Chicago Magazine,
4. Quoted in Steven Pearlstein, "Chicago Economist Wins Nobel
Prize: Lucas has Focused on Theoretical Issues," San Jose
Mercury News, Wednesday, October 11, 1995, p. 4A.
5. Ron Ross, "Anticipation," The North Coast Journal,
6. Michael Mandel, "Great Theory
As Far as it Goes,"
Business Week, October 23, 1995, p. 32.
7. Krugman, p. 204.