The reality of ‘irrational’ capitalist markets eventually exposed Lucas’ rational expectations theory
Michael Roberts is an Economist in the City of London and a prolific blogger
Cross-posted from Michael Roberts’s blog
Robert Lucas has died at the age of 85. Lucas was a leading mainstream neoclassical economist at the University of Chicago – the bastion of neoclassical equilibrium economic theory. In 1995, Lucas received a ‘Nobel prize’ for his theory of ‘rational expectations’. He was regarded by Greg Mankiw, the author of the main mainstream economics textbook used in universities, as “the most influential macroeconomist of the last quarter of the 20th century.”
It is an irony, given the body of his work, that when Lucas started studying economics, he considered himself a “quasi-Marxist” because he reckoned that it was the economic foundation of society that was the driver of history, not the ideas of individuals. The irony is that his main contribution to mainstream economics was eventually to present a theory that economic change was driven by the ‘rational’ action of ‘agents’ i.e, individuals as consumers.
What is ‘rational expectations’ theory? Apparently, economic changes are the product of agents who make ‘rational’ decisions on the basis of available information to maximise the ‘utility’ for each agent over their lifetime. Individual agent expectations thus drive output and prices in an economy, not some aggregated forces like class or exploitation. As economies are driven by individual expectations, markets tend towards some equilibrium state that ensures supply and demand are balanced – and are only disturbed by ‘shocks’ or by wrong decisions by monetary and fiscal authorities.
Lucas was widely acclaimed because he furthered mainstream theory that markets could work without crises or distortions as long as individuals have sufficient information to make ‘rational decisions’ in their own interests. So the reality of crises and inequalities was due not to capitalist markets but to ‘irrational’ decisions by authorities or unions interfering with markets.
In particular, Lucas attacked the Keynesian ‘aggregate demand’ theory of economies, namely the Keynesian conclusion that total demand could fall below total supply in an economy, leading to periods of high unemployment. Lucas argued that if governments intervened to increase money supply or increase spending to boost aggregate demand, they would distort the ‘rational expectations’ of individuals and only make things worse.
Moreover, Keynesian theory had no theoretical model that justified its conclusion of inadequate aggregate demand. And all empirical results must have a foundation in theory, in particular, a theory of individual agent decisions. Without that any policy conclusions drawn from Keynesian analysis would be wrong. This was called the Lucas critique, which came to dominate the application of macroeconomic analysis.
One example that Lucas presented was the failure of the Keynesian Phillips curve, namely that there was a trade-off between unemployment and inflation. Lucas argued that the apparent inverse relation between the two had been proven wrong in the 1970s when inflation rose with unemployment. That showed you cannot base policy on a statistical correlation without a theoretical base.
Lucas was right on both counts – in the sense that the Phillips curve has been proven empirically false as a guide to the relation between employment and inflation – see the body of work on this in several posts. But also, it must be right that any empirical evidence must be weighed and used to confirm or falsify a theory.
But the question is: what theoretical model? One of Lucas’s students, Paul Romer agreed with Lucas that Keynesian economic models “relied on identifying assumptions that were not credible.” And that the “predictions of those Keynesian models, the prediction that an increase in the inflation rate would cause a reduction in the unemployment rate, have proved to be wrong”. But that did not make Lucas’ own ‘rational expectations’ theory correct.
Nevertheless, Keynesian economists capitulated to the Lucas critique. During the Great Moderation (when inflation and unemployment were falling in the 1990s – and profitability was rising), mainstream Keynesian economics concentrated on explaining ‘business cycles’ or ‘fluctuations’ in an economy using ‘modern’ techniques of modelling from what it called ‘microfoundations’. Econometric analysis like the Phillips curve were ditched because such ‘correlations’ between employment and inflation had been proved wrong. The job now was not to look at macro or aggregate data but to work out some ‘model’ that started with some premises of ‘rational’ agent (consumer) behaviour or preferences and then incorporate some possible ‘shocks’ to the general equilibrium of the market and consider the number and probability of possible outcomes.
Thus were born the Dynamic Stochastic General Equilibrium (DSGE) models. They had equilibrium because they started from the premise that supply would equal demand ideally; they were dynamic because the models incorporated changing behaviour by individuals or firms (agents); and they were stochastic as ‘shocks’ to the system (trade union wage push, government spending action) were considered as random with a range of outcomes, unless confirmed otherwise).
This was a ‘bastardisation’ of the radical aspects of Keynesian theory,namely that capitalism did not grow smoothly and could not without periods of slump and depression. But now these only happened as ‘shocks’ to the harmony of the market. Lucas had succeeded in his critique in reducing Keynesian macro economics to a weak and feeble beast. No wonder he got a Nobel prize at the height of the neoclassical, neoliberal ascendancy in 1995.
Given his victory over the Keynesians; given the apparent success of the advanced capitalist economies in the 1990s; and given the neoliberal policies of reduced government ‘interference’ and ‘independent’ central banks, Lucas was confident that harmonious capitalist development was here to stay. In 2003, he made the now infamous statement that “macroeconomics in this original sense has succeeded: Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades.” As Romer remarked it “Using the worldwide loss of output as a metric, the financial crisis of 2008-9 shows that Lucas’s prediction is far more serious failure than the prediction that the Keynesian models got wrong.”
The reality of ‘irrational’ capitalist markets eventually exposed Lucas’ rational expectations theory.
Be the first to comment