The 50th anniversary of the publication of the Lucas Critique – an idea that changed the way macroeconomics is taught around the world – brings back personal memories for me. I experienced first-hand the “rational expectations” revolution in macroeconomics – ignited in large part by the Lucas Critique. I remember as a Yale undergraduate in the mid-1970s the paranoia of the old guard that greeted that revolution. Yale macroeconomists tended to have a jaundiced view of the “freshwater” thinking about rational expectations emanating from cities like Chicago, Minneapolis, Rochester and Pittsburgh, even though to me then, and to almost everyone in retrospect, the notion that expectations might be formed rationally hardly seems radical. Why did the old guard react so negatively to the new thinking? Why did it take so long for that new thinking to become mainstream?
The many years of denial in the 1960s and 1970s may be the most important lesson we should learn from the history of the Lucas Critique. That self-serving reluctance to learn from economic facts and logic seems as present today as it was then.
Before answering those questions, I cannot resist recognizing the comical element that often accompanies reporting about influential ideas in economics. Physicists win Nobel Prizes for things like showing that Einstein’s Theory of Relativity is confirmed by an analysis of the shape of bended light.
In contrast, when James Tobin won his Nobel for a theory of optimal stock portfolio selection, he explained it to the press as “don’t put all your eggs in one basket.” The next week the New Yorker magazine had a cartoon with someone expressing skepticism that the latest Nobel in Economics was won for having shown that a stitch in time saves nine.
The reason contributions to economic thinking can be the butt of such jokes is that they are formalizations of ideas that in some sense we already knew. But formalizations can be important because they show not just that intuition is right, but exactly why it is true, that is, how its truth emerges from and fits into a broader way of thinking about the world. In the process, the logic of many related truths that weren’t so clear are also brought to light.
In the case of the Lucas Critique, its author pointed out that rules of thumb about economic behavior from the past are subject to change if policy circumstances change. The way people set prices for their goods and labor in the market, for example, depends on their expectations of the prices of other goods and services they will have to buy. Past patterns of behavior in price and wage setting may not persist if policies change, and if those changes make people see that they will need to change their price setting behavior accordingly. For example, if an observable expansionary monetary policy causes people to expect prices in general to rise, everyone will be more demanding in the prices they charge for their own goods and services.
Or as Robert Lucas put it in his influential 1976 Carnegie-Rochester volume paper, Econometric Policy Evaluation: A Critique: “Given that the structure of an econometric model consists of optimal decision rules of economic agents, and that optimal decision rules vary systematically with changes in the structure of series relevant to the decision maker, it follows that any change in policy will systematically alter the structure of econometric models.”
The example that Lucas had most in mind was monetary policy’s effects on employment and real output. What we now call “the great inflation” of the 1960s and 1970s was front of mind in 1976. Today it is viewed as a colossal, persistent policy error. Students learn that the cause of the great inflation was that when our government increased its spending (both to fight the Vietnam War, and to achieve the ambitious domestic agenda of the Great Society objectives) the Federal Reserve accommodated the rising deficits by expanding its purchases of government debt, which produced accelerating inflation.
The Federal Reserve at the time (self-servingly) claimed that it had not caused the inflation. And Fed Chair Arthur Burns (who led the Fed from February 1970 through January 1978) even argued that monetary policy was powerless to end the inflation – a view that led him to advocate price controls to President Richard Nixon. Policy makers also continued to argue that rising unemployment could be addressed with further monetary expansion, and that this could be done without raising the level of inflation.
That thinking was based on the “Phillips Curve” – an empirical regularity documented from past behavior – which suggested that one could forecast the amount of added employment and real GDP they could achieve by expanding the money supply by a given amount.
That mechanical view of the effects of monetary policy ignored that people form expectations by observing government and central bank policies and rely upon those expectations when entering into labor bargains and purchase decisions. Once people learn that higher monetary growth led to higher inflation, the policy implications of the Phillips Curve must change because expansionary monetary policy must become less effective in raising employment and output; people see inflation coming and bid up their own prices accordingly, which offsets the expansionary effect of the policy.
Another way to say this is that the attempt to get more output by expanding the money supply works by “tricking” people to underprice their goods and services. But you cannot continue to get large labor and output consequences from a never-ending repetition of the same trick. People catch on.
You might marvel that many macroeconomists and policy makers needed to be reminded of this simple insight as late as 1976. After all, inflation had been raging for over a decade. Milton Friedman’s American Economic Association Presidential address in 1967 had already made precisely the same point as the Lucas Critique less formally a decade before.
Lucas was a master theorist whose formal models showed precisely how optimizing behavior by individuals undoes the effectiveness of predictable monetary expansion. On the other hand, the intuition was already readily apparent as early as 1967.
I doubt that the acceptance of Lucas’s logic is understandable simply as a triumph made possible by more formal logic than Friedman’s. My guess is that policy makers and economists stubbornly adhered to bad ideas because they were personally invested in previous policy narratives, and this led them to try to preserve their influence by ignoring logic and facts to avoid accountability for their errors.
The many years of denial in the 1960s and 1970s may be the most important lesson we should learn from the history of the Lucas Critique. That self-serving reluctance to learn from economic facts and logic seems as present today as it was then.
The Trump Administration says that trade deficits are evidence that a country is being abused by others and that tariff policies will promote growth by substantially onshoring the global supply chain. Both those claims ignore a vast theoretical and empirical literature in economics. That literature shows that trade deficits today mainly reflect the desire of foreigners to invest in the US. And economic evidence is unanimous in showing that tariffs harm growth by limiting our pursuit of comparative advantage in supplying some goods and services.
The Democrats persist in their own denials of economic logic and facts, of course. For example, they fail to see any connection between increasingly subsidized housing risk in the 1990s and 2000s and the 2008 financial crisis.
A list of several of the most important false economic beliefs that serve as the basis for policy advocacy can be found in the recent book, The Triumph of Freedom: Debunking the Seven Great Myths of American Capitalism, by Phil Gramm and Donald Boudreaux. Sadly, however, those myths persist in spite of the writings of economists, even when the evidence is very one-sided.
It is striking, in retrospect, how long it took for policy makers and academics to be forced to incorporate the basic insights of Friedman, Lucas and their collaborators into their policy toolkit, and how poor macroeconomic performance we suffered because of that protracted learning.
But the ultimate success of the Lucas Critique at least points in a hopeful direction. Economic policy makers can’t ignore that businesses and households eventually will test the veracity of their words and the effectiveness of their policies.
