BusinessWeek: October 23, 1995

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 News: Analysis & Commentary: COMMENTARY

COMMENTARY: GREAT THEORY...AS FAR AS IT GOES

Few of his peers would deny that Robert E. Lucas Jr., winner of the 1995 Nobel Memorial Prize in Economic Sciences, deserves the award. Indeed, Lucas, a professor at the University of Chicago, was this year's top choice in the Nobel prize betting pool run out of the University of California at Berkeley.

The reason? Starting in the mid-1970s, Lucas and his followers virtually demolished the Keynesian macroeconomics that had prevailed during the postwar era. Activist economists had believed that government could reliably affect the economy with fiscal and monetary policy. But Lucas argued persuasively that workers and companies have "rational expectations": They anticipate the government's actions in a way that makes intervention less effective. For example, the goal of an investment-tax credit may be to give a quick boost to capital spending. Yet the theory of rational expectations says that rather than boosting investment, savvy companies will simply delay their pending plant and equipment spending until the credit takes effect.

REALITY CHECK. The rational-expectations revolution that Lucas pioneered still dominates economic policymaking. The unwillingness of either the Bush or the Clinton Administrations to take strong measures against the 1990-91 recession and its aftermath reflected the influence of Lucas and his colleagues. In 1994, Federal Reserve Chairman Alan Greenspan suggested that hiking short-term interest rates would hold down long-term rates as investors lowered their views of future inflation, an idea that owes much to Lucas' notion of rational expectations.

Yet as much as Lucas deserves Nobel recognition, the theory of rational expectations has not lived up to its original promise. Unfortunately, models built on rational expectations do not reflect the real world as well as the old Keynesian models that they were supposed to replace. Moreover, like the worst type of urban renewal, the proponents of rational expectations have razed without rebuilding--leaving economists without the theoretical tools to deal with issues such as rampant technological change and intense global competition.

To be sure, the idea of rational expectations has tremendous intellectual appeal. Before Lucas, economists viewed workers and companies as automatons, reacting in predictable ways. By contrast, the theory of rational expectations assumes that ordinary people can understand and forecast the economy, on average, as well as economists do.

But Lucas' theory leads to some unappealing conclusions. For one, it implies that most unemployment is voluntary, even in recessions--a result that would surprise most jobseekers. Similarly, believers in rational expectations often end up arguing that business cycles are illusions.

LEFT IN THE DUST. Another problem: Most economic forecasting models still have a Keynesian core. They predict that the economy speeds up when government spending increases and slows down when interest rates rise--despite what the theory of rational expectations says. The result has been an enormous split between the forecasters and the economic theorists.

However, the real tragedy of rational expectations is that it supports a philosophy of government inaction at a time of rapid economic change. Will technology and free trade create jobs or destroy them? Raise incomes or lower them? What measures will increase growth? All are current conundrums that deeply concern Americans, yet are unaddressed by rational expectations. Even Lucas has shifted his attention in recent years to studying the factors determining long-run growth. Would it were so--that his new area of research be as influential as his old.

By Michael J. Mandel
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