Thus passes Robert Lucas

Farewell to the most influential macroeconomist of his generation.

Photo by Ahmed Yaaniu on Unsplash

Robert E. Lucas Jr., generally acknowledged as the most influential macroeconomist of the late 20th century, passed away today at the age of 85. He was a towering figure, on a level with John Maynard Keynes or Milton Friedman, though his name is far less known outside of academic circles.

From the first time I took a macroeconomics class, I found Lucas to be a fascinating figure, and in some ways an enigmatic one. He helped steer the profession toward the highly formalized mathematical models we now call “DSGE”, yet his own most influential paper used only simple math and logical arguments. Few of his own theories are used today, or even given much credence by macroeconomists, but his arguments about how to do economic theory — and how not to do it — remain the foundation of the field.

Lucas’ most famous work, by far — and the work that won him a Nobel in 1995 — was about how to fight recessions. In a landmark 1976 paper entitled “Econometric Policy Evaluation: A Critique”, he argued that the policies macroeconomists were recommending at the time made no sense, because they didn’t take people’s shifting expectations into account.

Suppose that you look at the past 50 years of macroeconomic history, and you notice that whenever inflation is high, unemployment is low. So you decide “Oh hey, I can use this fact to keep unemployment low forever, by having the central bank pump up inflation whenever there’s a recession!” Sounds clever, but the logic is flawed, because it doesn’t take human rationality into account. If businesses see that inflation is generally much higher than it used to be, they might reset their mental baseline — whereas before, they would take 4% inflation as the signal of an economic boom, and hire a bunch of workers, now 4% is just an average level of inflation, thanks to the new central bank policy. So now the central bank has to raise inflation by 6% to get businesses to think there’s a boom and hire a bunch of workers. Then 6% becomes the new normal, and so on. Eventually you either get hyperinflation, or you wind up with the same old level of unemployment at a much higher average level of inflation. Neither of those is a good outcome.

You can see why this line of argument resonated in the late 1970s.

So if human beings always catch on to whatever policy you’re trying to use to manipulate their behavior, what do you do? Lucas basically said you should do three things:

1. Assume that people catch on very quickly to whatever is happening in the economy, and adjust their expectations accordingly. (This is called “rational expectations”.)

2. Build a model of the economy that’s based on things that policy can’t easily change — technology, people’s preferences, resource constraints, and so on.

3. Have policymakers make policy according to set rules, instead of their own ad-hoc discretion, so that economists can analyze the effects of policies by looking at past data (since they’ll know that policy was constant).

None of these three ideas were original to Lucas, and other economists had made versions of the same critique. But Lucas brought it all together. He combined a clear and forceful logical argument that economic theory was being done all wrong with a complete policy program for making it right. No one else had done that.

And in short order, all three of Lucas’ recommendations had been wholeheartedly embraced by the macroeconomics profession. Rational expectations became the basis of almost all macroeconomic theories. The quest for “structural” models of the economy led to what we now call Dynamic Stochastic General Equilibrium models, or DSGE. And the idea of monetary policy made by rules rather than discretion became a key feature of DSGE models.

In other words, macroeconomics after Lucas was Lucasian, and it remains largely so to this day. That doesn’t mean Lucas created absolute consensus in the field — most macroeconomists will have some kind of problem with at least one of Lucas’ basic ideas, and many will have problems with all three. But credible alternatives took a very long time to materialize. In the meantime, Lucas and the other macroeconomists he worked with — most notably Thomas Sargent and Edward Prescott — did a lot of work in the 1980s to solidify Lucasian macroeconomics into a paradigm that anyone in the field could pick up and use. That follow-up effort crystallized Lucas’ status as the most influential macroeconomist of his time.

Perhaps the most paradoxical thing about Lucas, though, was that although his most famous work was about business cycles, it wasn’t really the topic he cared about most. Over the course of his career, he shifted toward economic growth theory. And in 2003 he argued that central banks had gotten good enough at stabilizing the economy where the harms from recessions are small enough to essentially not matter at all:

Macroeconomics was born as a distinct field in the 1940’s, as a part of the intellectual response to the Great Depression….[in order to] prevent the recurrence of that economic disaster. My thesis in this lecture is 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. There remain important gains in welfare from better fiscal policies, but I argue that these are gains from providing people with better incentives to work and to save, not from better fine-tuning of [the macroeconomy]. Taking U.S. performance over the past 50 years as a benchmark, the potential for welfare gains from better long-run, supply-side policies exceeds by far the potential from further improvements in short-run demand management.

That one line — “[the] central problem of depression prevention has been solved” — would come back to haunt Lucas’ legacy, since it came only five years before the Great Recession. But his overall argument illustrates something fundamental about how Lucas looked at the economic world. Basically, he thought that in the face of long-term economic growth, recessions were a second-order problem — as long as they didn’t get so severe that they caused the whole economic system to break down. (You can see echoes of Lucas’ argument in Tyler Cowen’s 2018 book Stubborn Attachments.)

There’s a compelling logic to this idea. The Panic of 1873 and the Long Depression that followed are interesting historical events, and they were certainly painful and terrible for some of the people who lived through them. But ultimately they’re a footnote in the story of rising technological and economic growth — barely a blip on the graph of rising living standards.

Lucas believed that macroeconomists’ top priority shouldn’t be ironing out every little bend and dip and squiggle in that graph, but to find ways to bend the curve ever upward — especially for poor countries. In a 1988 paper, he wrote:

Is there some action a government of India could take that would lead the Indian economy to grow like Indonesia's or Egypt's? If so, what, exactly? If not, what is it about the ‘nature of India’ that makes it so? The consequences for human welfare involved in questions like these are simply staggering: Once one starts to think about them, it is hard to think about anything else.

Seeing the miraculous increases in human living standards in countries like South Korea that successfully went from poverty to industrialization, it’s hard to argue with Lucas’ focus.

But over the course of the second half of his career, Lucas was only able to make very marginal contributions toward answering those big questions. The growth model he developed in that 1988 paper was not considered to be particularly useful by growth theorists — its main conclusion, that you can grow an economy infinitely by continuing to build up ever more human capital, just isn’t credible; eventually people max out on schooling and skills. Later growth theorists, like Paul Romer (Lucas’ student, and another Nobel winner), would introduce more realistic models in which investment in researching new ideas takes center stage. But even these models are difficult to test empirically, and the question of whether research investment hits diminishing returns remains unresolved.

Ultimately, the kind of analysis that had propelled Lucas to superstardom in the world of business cycles was less effective when tackling the problem of economic growth. Lucas was at his best when he was using simple, powerful logic to criticize the assumptions behind economic theories. That kind of intelligence is inherently destructive — its purpose is to clear away the deadwood and point the direction to something newer and (hopefully) better. Constructing a theory of long-term growth is a different sort of challenge entirely, and doing the rigorous empirical work necessary to even start to test that theory was just not in Lucas’ wheelhouse. Fortunately, he did manage to direct some students like Romer toward the problem.

In the late 2000s and 2010s, Lucas’ attention was pulled back toward the field of business cycle theory that he had revolutionized three decades prior. The Great Recession seemed to upend many of the conclusions Lucas and his friends and disciples had reached about how recessions worked. It was caused by a financial crisis, which contradicted Ed Prescott’s technology-driven explanation of business cycles. It was the biggest downturn since the 30s, and monetary policy failed to contain it, which put paid to Lucas’ belief that the “problem of depression prevention” had “been solved”. And the DSGE models that Lucas & co. had spent years ideating and promoting both failed to foresee the possibility of the crisis, and were too rigid and opaque to be of much help to policymakers in fighting it.

Lucas spent considerable time making qualified defenses of the paradigm he had created. In a guest article in The Economist in 2009, he pointed out that Ben Bernanke and other monetary policymakers whose quick actions reduced the severity of the crisis were themselves purveyors of Lucasian macroeconomic theory:

Both Mr Bernanke and Mr Mishkin are in the mainstream of what one critic cited in The Economist's briefing calls a “Dark Age of macroeconomics”. They are exponents and creative builders of [DSGE] models and have taught these “spectacularly useless” tools, directly and through textbooks that have become industry standards, to generations of students. Over the past two years they (and many other accomplished macroeconomists) have been centrally involved in responding to the most difficult American economic crisis since the 1930s. They have forecasted what can be forecast and formulated contingency plans ready for use when unforeseeable shocks occurred. They and their colleagues have drawn on recently developed theoretical models when they judged them to have something to contribute. They have drawn on the ideas and research of Keynes from the 1930s, of Friedman and Schwartz in the 1960s, and of many others.

This was a substantial moderation of Lucas’ earlier views. For decades, Lucas had spoken of Keynesian economics in the most scathing and dismissive terms, as a dead paradigm; in 2009, he praised Bernanke for drawing on Keynes’ ideas. In a 2008 email he said “I guess everyone is a Keynesian in a foxhole.” And in an interview with the WSJ, he endorsed both monetary and fiscal stimulus, using very Keynesian language:

If you think Bernanke did a great job tossing out a trillion dollars, why is it a bad idea for the executive to toss out a trillion dollars? It's not an inappropriate thing in a recession to push money out there and trying to keep spending from falling too much, and we did that.

This shows that Lucas had the (in my experience, unusual) ability to stay open-minded and skeptical even about the ideas that had made him famous. In an interview around the same time, Lucas also admitted that he had changed his mind about the very basic question of what causes recessions:

I was convinced by Friedman and Schwartz that the [Great Depression] was induced by monetary factors…I concluded that a good starting point for theory would be…that all depressions are mainly monetary in origin…Ed Prescott was skeptical about this strategy from the beginning…I now believe that the evidence on post-war recessions (up to but not including the one we are now in) overwhelmingly supports the dominant importance of real shocks. But I remain convinced of the importance of financial shocks in the 1930s and the years after 2008. Of course, this means I have to renounce the view that business cycles are all alike!

Cynics are going to look at this and wonder whether the whole Lucas research program was worth pursuing in the first place. What’s the point of thinking about the economy with the kind of simple, logical arguments that Lucas used in the 70s and 80s, if those arguments don’t lead to dependable conclusions about the economy? Why did all the brilliant macroeconomists who followed Lucas spend decades on theories that had to be replaced with ancient Keynesianism the next time a big recession came around?

Those are fair questions to ask. And I do think Lucas and his followers were far too confident — and far too aggressive — in presenting their ideas as a clean break with the past, back in the 70s and 80s. If they had been less insistent on wiping the slate clean of Keynesianism and starting afresh, their theories would have been more helpful when the rubber hit the road.

That said, I think that macroeconomics is a very very hard subject, given the complexity of the phenomena involved and the paucity of good empirical data. Lucas’ criticisms of the way economic policy had been done before 1976 were trenchant and correct, and even if he didn’t ultimately find a better way to do things, he pointed the way toward what will almost certainly be necessary to find a better way. Just as in growth theory, Lucas’ great strength was in asking good questions, and motivating people to find the solutions. When knowledge is scarce and ignorance is vast, the most important thing is to start looking.

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