The idea sounds simple enough: People are smarter than governments think they are, and are certainly too smart to fool very much or very often.
But this was heresy–in the world at large, if not at the University of Chicago–when Robert E. Lucas Jr., a young U. of C. economist, began expounding it in 1976. Now Lucas’ insight has changed the way governments work and the way economists, both conservative and liberal, view the world.
For this, Lucas, now 58, won the Nobel Memorial Prize for Economics Tuesday, becoming the eighth University of Chicago professor–and the fifth in six years–to capture the prize. No other institution has come close to dominating a Nobel field as the Hyde Park university rules the economic prizes.
“Break up the team,” joked Gary Becker, the U. of C. economist who won the Nobel Prize in 1992. “The Bulls couldn’t do a four-peat, but now we’ve done a five out of a six-peat. This is a dynasty.”
More Top Picks Best Clamp Desk Lamps For Students
Like many Nobel Prize economists, Lucas won for a theoretical breakthrough that has since become accepted, even obvious.
In his case, he undermined the orthodoxy of Keynesian economics, which ruled the economic roost in the postwar years by teaching that governments could gently fine-tune the economy. The Keynesians believed that government could steer investment, raise output or bring down unemployment by using the tools–taxes, government spending and the amount of money in circulation–at its command.
In a press conference Tuesday, Lucas said the primary impact of his work has been “to let us see that guiding and fine-tuning of the economy through monetary and fiscal policy were more or less useless.”
The reason, he said, is the Keynesians “assumed a lot of stupidity on the part of the ordinary system.”
But people were smarter than that, Lucas wrote. He said governments assumed they could make people change their economic habits, based on what people had done in the past.
In fact, he said, people use “rational expectations,” which is the name of the theory that is central to his work. This means people understand what the government is trying to do and, using their own knowledge and information, frame expectations of what this means to them. Then they act on these expectations.
The government had expected a predictable response, like pushing a button on a machine. But people change in a changing situation, Lucas wrote, and these changes themselves alter the landscape, making government actions unpredictable and often vain.
The example most often cited to illustrate Lucas’ contributions is his undermining of the “Phillips curve.” This theory said that, in a recession, the government should pump more money into an economy, either through tax cuts or higher spending. The result might be inflationary but it also would stimulate the economy and create jobs. The Phillips curve, in fact, said a certain amount of inflation was needed to keep employment up.
But during the 1970s, most of the Western world suffered from “stagflation”–high unemployment and high inflation at the same time–and Lucas’ work showed why.
Government attempts to stimulate the economy, he said, didn’t surprise people. Instead, they figured out that prices would go up. So workers asked for more money and businesses raised their prices. The result: higher inflation, but no more economic activity and no new jobs–not at all what the policymakers wanted.
“You have to really go back to the ’60s,” Lucas said, “to remember what it was like then. But the idea was that, with a well-chosen tax cut or a well-chosen movement in interest rates, you could manipulate the level of investment, the level of private consumption, and in that way you could manipulate the overall level of production and employment in the economy.
“That all presupposed that people were going to be rather simple-minded in the way they responded to changes in taxes or interest rates,” he said. “Nobody talks with the kind of authority and optimism that everyone talked with in the ’60s. I think people are becoming more and more aware of the limits of monetary and fiscal policy.”
The same sort of “rational expectations” affect investments, stock prices and savings–in fact, virtually the entire economy. But because these expectations change as the situation–including government policy–changes, it’s almost impossible to predict outcomes.
Lucas, Becker and other Nobel laureates from the University of Chicago are the intellectual heirs of earlier Hyde Park laureates, including Milton Friedman and George Stigler. The university’s domination of the prizes reveals a cross-fertilization of ideas that results from exposing brilliant economic minds to each other in an open and competitive atmosphere.
“The atmosphere here is very conducive to research,” Becker said. “You don’t have people always running off to Washington. There’s a willingness to gamble on unconventional ideas and an open atmosphere.”
Chicago economists, unlike most university economists, are generalists, not specialists, U. of C. economist Lars Peter Hansen said. “We resist divisions and sub-areas. There’s more of a generalized atmosphere and an emphasis on how far you can push economic analysis.”
Becker, the 1992 winner, used the theory of “rationality” to show how economic expectations affect private decisions–to get married, for instance, or to have children. Lucas, by contrast, applied “rationality” to macroeconomics–the monetary and fiscal policies of government.
The Royal Swedish Academy of Sciences, in citing Lucas for the Nobel Prize, said he “is the economist who has had the greatest influence on macroeconomic research since 1970.
Basically, Lucas’ teaching argues for less government action, not more, and so gives ammunition to conservative politicians. But he is admired by both sides of the political fence, and is equally skeptical of both sides.
“A lot of economic theory is based on trickery,” Lucas told the press conference. “The Republicans are way too optimistic about using tax cuts to stimulate the economy, just like the Democrats are way too optimistic about government assistance.”
“He’s done major work which has revolutionized macroeconomic thinking,” Northwestern University economist Robert Eisner, a liberal, said of Lucas. “He has forced many of us to sharpen our thinking. `Rational expectations’ has led people to think carefully about the implications of any action, how people are likely to react. All this should make us clever and more careful.”
“He shoots a lot of holes in the Keynesian analysis,” Becker, a conservative said. “There are very few straight Keynesians anymore.”
Eisner warns that Lucas’ work can lead to despair, to a “notion of political impotence, that there’s nothing that government can do.” But he agrees that Lucas himself doesn’t go this far, and Lucas himself feels that government can be effective, but only if it carefully calls its shots.
“What he does is put economists as policy advisers on a more cautious footing,” Hansen said. “He’s not going to deny the importance of monetary policy on inflation.”
In other words, government can control inflation by keeping tight controls on the growth of the amount of money in circulation. According to Lucas, it is doing that fairly successfully now, at least partly because of his work.
“There’s more attention now,” he said, “to using monetary policy to keep inflation down, which is, in fact, the only thing monetary policy can do.”
More Top Picks Best Snow Roof Rakes
Apart from this, he said, tools such as tax cuts–including the tax cuts that supposedly fueled the boom of the Reagan administration’s years–don’t work.
“We had some very good years under Reagan,” he said, “but the tax cuts had nothing to do with it . . . That’s been overblown. Tax cuts don’t have some kind of magic effect on growth.”
Lucas was feeding his cat at 6 a.m. in his New Town apartment on Chicago’s North Side and working a crossword puzzle when he got the call from Stockholm, telling him he had won the $1 million prize.
The money and the fame won’t change his life much, he said. “I’m doing what I want to do, teaching and research.”
A native of Yakima, Wash., Lucas earned his undergraduate and doctoral degrees at the University of Chicago and began teaching there in 1975. He has coauthored a 1989 textbook with his second wife, Nancy Stokey, another U. of C. economist.
Lucas has two sons, Stephen, 35, a bond trader at Chemical Bank in New York City, and Joe, 30, a graduate student in history at Boston University.
“Stephen believes that I can use my economics to tell him how to make money trading bonds,” Lucas said. “And I keep trying to explain to him that he’s wrong. I have no idea how to use economics to make money trading bonds. And I don’t think anybody else does, either.”