Robert E Lucas: The economist who assumed our expectations were rational

Keynesian economics and Lucas

The 1970s turned out to be a crucial turning point for economics as a discipline. Since the Great Depression (1929-1939), Keynesian ideas had dominated policymaking and macroeconomics. Before Keynes, the classical view of economics saw little role for government intervention. However, the Great Depression changed all that.

Lucas’s family was a good example. He was born in 1937 to parents of Republican leanings. But shortly after his birth, their family’s restaurant business went bankrupt, thanks to the economic depression, and his parents became supporters of the New Deal (a policy approach that saw government as the prime mover). However, the stagflation — a curious combination of persistently high inflation and stagnant economic growth — of the 1970s was immune to Keynesian solutions. That is when Lucas’s critique made a difference.

What does rational expectations mean in economics?

Lucas will be remembered for developing the “rational expectations” approach to macroeconomics. Before the 1970s, there was little clarity on how expectations are formed. Mostly, it was thought that they were either fixed or backward-looking. For example, if inflation was 4% for the past two years, the belief was that people’s expectation of future inflation would be either fixed at 4% or be based on past inflation. But Lucas argued that such a view would imply irrational behaviour by humans at the macro level when at the micro level (read personal level), the discipline expected humans to behave rationally.

To act rationally means to act in one’s own interest and by making use of the information available. Lucas argued that if people can see that other variables — such as money supply or employment — are trending in a particular direction, then their expectation of inflation would change. This would be the rational behaviour.

For instance, if the central bank is pumping lots of money into the economy this year, perhaps in a bid to boost economic activity, then Lucas’ “rational expectation” model suggests that people will realise that inflation will go up. In other words, their expectations will change in a rational manner as the situation evolves.

What is the real-world impact of this theory?

This “assumption” of rational expectations has massive policy implications.

Here’s an example: Imagine that the government decides to cut taxes in a bid to boost consumption, The idea is that lower taxes will leave more money in the hands of the people and this extra money will be spent buying new things, and, as a result, boost overall economic activity and reduce unemployment.

But, if one plugs in Lucas’s assumption of rational expectations, the whole policy initiative can become ineffective. It can be argued that as soon as the government cuts taxes, people will realise that the government’s budget will go into a deficit (that is, revenues will dip while expenditures stay the same).

Further, people will realise that to bridge this deficit, the government will eventually have to raise the taxes — say in a year or two. As a result, rational behaviour would suggest that people simply “save” the additional money coming to them from the latest tax cuts so that they can pay the higher taxes later. As people save (instead of spending), the government’s original intention of boosting economic activity fails.

Lucas argued that standard macroeconomic policies cannot improve economic outcomes such as reducing unemployment. Lucas had started out as a student of history, but shifted to economics after realising that economic factors were often the key drivers of history.