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Friday, December 1, 1995

Whose Economics, Which Economic Liberalism?

Lucas' Theories Burst Economists' Keynesian Hubris

Robert Lucas, a professor of economics at the University of Chicago, was awarded the 1995 Nobel Prize in Economic Science in October. The Swedish Royal Academy of Science declared that Lucas was “the economist who has had the greatest influence on macroeconomic research since 1970.” To economists of my generation, Lucas’ approach to economic science has been treated as the methodological gospel. But as pundits quickly pointed out, Lucas’ theories had a tremendous public-policy influence by bursting the Keynesian hubris of the profession that was dominant in the 1950s and 1960s.

Lucas’ theoretical innovation was to insist that the behavioral assumptions of so-called macroeconomic theory had to be consistent with those employed in microeconomic theory. Economic actors cannot be assumed to be persistently fooled by policy-makers. Rational actors will come to know the model of the economy that policy-makers are employing in designing policy.

At first blush, the policy implication of Lucas’ “rational expectations hypothesis” was that traditional Keynesian policies of fine-tuning were flawed because they failed to take into account how economic actors would anticipate government policy. If unemployment, for example, rises by a couple of percentage points, then traditional Keynesian theory suggests that the Federal Reserve should ease monetary policy to combat this rise. But if union leaders watch Fed policy, they will notice that loosening monetary policy will lead to inflation and thus will adjust future wage demands upwards. In doing so, they will offset completely the intended effect of the fine-tuning policy. Unemployment will not be reduced, but inflation will persist. Only unanticipated policies will have an effect on the economy; anticipated policies will be fully incorporated in the decision-making of economic actors. Stable and predictable rules in policy will outperform the discretionary fine-tuning of Keynesian economic policy in terms of combating inflation and unemployment, and promoting economic growth.

Subsequent developments in economic theory have questioned this first-blush policy implication, but the technique of “rational expectations” became part of the staple tool-kit of modern economists. On a theoretical level, Lucas led a revolution intended to eliminate the unnecessary split between microeconomic and macroeconomic theory, and the loose theorizing that resulted from that split. On a policy level, Lucas dealt the old Keynesian system its final blow. Mises and Hayek had challenged the theory at its core (and were largely ignored). Milton Friedman had shown its internal theoretical and empirical weaknesses, James Buchanan had demonstrated the shortcomings of its political economy, but Lucas destroyed the logic of the entire enterprise. In this sense, Lucas harked back to the pre-Keynesian theories of monetary economics and appeared to be offering a “neo-Austrian” theory. In fact, Lucas acknowledged this influence in the early 1970s. With the failure of the Keynesian system, it was time to reassess the writings of scholars such as Mises and Hayek, especially Hayek’s work on the business cycle.

Lucas’ translation of Hayek’s project into modern technical economics, however, was challenged quite quickly by such contemporary Austrian economists as Gerald O’Driscoll, Roger Garrison, and William Butos. The model that Lucas had built, which certainly possessed a certain laissez-faire conclusion to it, was not consistent with many of the core claims of Austrian economics from Menger to Mises. Austrians no doubt rejected the split between microeconomics and macroeconomics, and they postulated that economic actors learn and adjust their behavior accordingly through time. But Lucas treated choice as a mechanical procedure; the choice environment was not one of uncertainty and ignorance, but rather one of risk and rational search. Moreover, the theoretical and policy implications of the logic of this situation were unsettling to economists of Austrian sensibilities—e.g., money was assumed to be neutral and simply a veil, not the essential link in transactions.

No doubt the logic of Lucas’ argument was impeccable, and no doubt the implication of his economic logic was largely a non-interventionist position, so why aren’t contemporary Austrian economists rejoicing in the honor bestowed upon Lucas by the Nobel committee?

Austrian economics is not just free-market economics—it is something much more than that. Not all arguments that favor the free market over government intervention are equal. As economic scientists all we are entitled to ask is “How does theoretical innovation improve our understanding of human action and social cooperation?” On the other hand, as intellectuals and enlightened citizens it is incumbent on us to ask “Whose economics, which economic liberalism?”

If we allow modeling techniques to crowd out questions about human behavior which cannot fit into the model, yet are essential for understanding how the market functions to coordinate our decisions, then the simplified model will distort our view of the market. If this “weak” view of the market economy is then employed as a background to a defense of economic liberalism, then the case for economic liberalism will also be weak and vulnerable to challenge.

Robert Lucas is a brilliant man. But his theory of human behavior fails to account for the diversity of individual perception, his theory of market equilibrium mischaracterizes the economic order, and the policy implications that flow from his theories render the laissez-faire position vulnerable on several fronts (something that has already been exploited by New Keynesian economics of the type championed by Joseph Stiglitz and Gregory Mankiw).

Modern economic research, as influenced by Lucas, has produced ever more refined techniques and models, but the cost of this increased specialization has been a loss of relevance for the broader human conversation. Economic science has become increasingly narrow and inaccessible to the layman. But as Ludwig von Mises argued:

It is a fateful error on the part of our most valuable contemporaries to believe that economics can be left to specialists in the same way in which various fields of technology can be safely left to those who have chosen to make any one of them their vocation. The issues of society’s economic organization are every citizen’s business. To master them to the best of one’s ability is the duty of everyone.

Thus, we can agree that Lucas has greatly influenced modern economics, yet—despite substantial agreement in the policy arena—still express concern that economics has been pushed to become increasingly precise about less and less, thus losing its relevance for the everyday life of business and politics.

  • Peter Boettke is a Professor of Economics and Philosophy at George Mason University and director of the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics at the Mercatus Center. He is a member of the FEE Faculty Network.