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Bob Lucas and his papers

My first post described a few anecdotes about what a warm person Bob Lucas was, and such a great
colleague. Here I describe a little bit of his intellectual influence, in a form that is I hope accessible to
average people.

The “rational expectations” revolution that brought down Keynesianism in the 1970s was really much
larger than that. It was really the “general equilibrium” revolution. 

Macroeconomics until 1970 was sharply different from regular microeconomics. Economics is all about
“models,” complete toy economies that we construct via equations and in computer programs. You can’t
keep track of everything in even the most beautiful prose. Microeconomic models, and “general
equilibrium” as that term was used at the time, wrote down how people behave — how they decide what
to buy, how hard to work, whether to save, etc.. Then it similarly described how companies behave and
how government behaves. Set this in motion and see where it all settles down; what prices and quantities
result. 

But for macroeconomic issues, this approach was sterile. I took a lot of general equilibrium classes as a
PhD student — Berkeley, home of Gerard Debreu was strong in the field. But it was devoted to proving
the existence of equilibrium with more and more general assumptions, and never got around to
calculating that equilibrium and what it might say about recessions and government policies. 

Macroeconomics, exemplified by the ISLM tradition,  inhabited a different planet. One wrote down
equations for quantities rather than people, for example that “consumption” depended on “income,” and
investment on interest rates. Most importantly, macroeconomics treated each year as a completely
separate economy. Today’s consumption depended on today’s income, having nothing to do with whether
people expected the future to look better or worse. Economists recognized this weakness, and a vast and
now thankfully forgotten literature tried fruitlessly to find “micro foundations” for Keynesian economics.
But building foundations under an existing castle doesn’t work. The foundations want a different castle. 

Bob’s “islands” paper is famous, yes, for a complete model of how unexpected money might move output
in the short run and not just raise inflation. But you can do that with a half a page of simple math, and
Bob’s paper is hard to read. It’s deeper contribution, and the reason for that difficulty, is that Bob wrote
out a complete “general equilibrium” model. People, companies and government each follow described
rules of behavior. Those rules are derived as being the optimal thing for people and companies to do
given their environment. And they are forward-looking. People think about how to make their whole lives
as pleasant as possible, companies to maximize the present value of profits. Prices adjust so supply =
demand. Bob said, by example, that we should do macroeconomics by writing down general equilibrium
models. 

General equilibrium had also been abandoned by the presumption that it only studies perfect economies.
Macroeconomics is really about studying how things go wrong, how “frictions” in the economy, such as

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the “sticky” wages underlying Keynesian thinking, can produce undesirable and unnecessary recessions.
But here too, Bob requires us to write down the frictions explicitly. In his model, people don’t see the
aggregate price level right away, and do the best they can with local information. 

That is the real influence of the paper  and Bob’s real influence in the profession. (Current
macroeconomic modeling reflects the fact that the Fed sets interest rates, and does not control the
money supply.) You can see this influence in Tom Sargent’s textbooks. The first textbook has an
extensive treatment of Keynesian economics. It’s about the most comprehensible treatment there is —
but it is no insult to Tom to say that in that book you can see how Keynesian economics really doesn’t
hang together. Tom describes how, the minute he learned from Bob how to to general equilibrium,
everything changed instantly. Rational expectations was, like any other advance, a group effort. But what
made Bob the leader was that he showed the rest how to do general equilibrium. 

This is the heart of my characterization that Bob is the most important macroeconomist of the 20th
century. Yes, Keynes and Friedman had more policy impact, and Friedman’s advocacy of free markets in
microeconomic affairs is the most consequential piece of 20th century economics. But within
macroeconomics, there is before Lucas and after Lucas.  Everyone today does economics the Lucas
way. Even the most new-Keynesian article follows the Lucas rules of how to do economics. 

Once you see models founded on complete descriptions of people, businesses, government, and
frictions, you can see the gaping holes in standard ISLM models. This is some of his stinging critique,
such as “after Keynesian macroeconomics.” Sure, if people’s income goes up they are likely to consume
more, as the Keynesians posited. But interest rates, wages, and expectations of the future also affect
consumption, which Keynesians leave out. “Cross equations restrictions” and “budget constraints” are
missing. 

Now, the substantive prediction that monetary policy can only move the real economy via unexpected
money supply growth did not bear out, and both subsequent real business cycles and new-Keynesianism
brought persistent responses. But the how we do macroeconomics part is the enduring contribution. 

The paper still had enduring practical lessons. Lucas, together with Friedman and Phelps brought down
the Phillips curve. This curve, relating inflation to unemployment, had been (and sadly, remains) at the
center of macroeconomics. It is a statistical correlation, but like many correlations people got enthused
with it and started reading it as stable relationship, and indeed a causal one. Raise inflation and you can
have less unemployment. Raise unemployment in order to lower inflation. The Fed still thinks about it in
that causal way. But Lucas, Friedman, and Phelps bring a basic theory to it, and thereby realize it is just a
correlation, which will vanish if you push on it. Rich guys wear Rolexes. That doesn’t mean that giving
everyone a Rolex will have a huge “multiplier” effect and make us all rich. 

This is the essence of the “Lucas critique” which is a second big contribution that lay readers can easily
comprehend. If you push on correlations they will vanish. Macroeconomics was dedicated to the idea that
policy makers can fool people. Monetary policy might try to boost output in a recession with a surprise bit
of money growth. That will wok once or twice. But like the boy who cried wolf, people will catch on, come
to expect higher money growth in recessions and the trick won’t work anymore. 

Bob showed here that all the “behavioral” relations of Keynesian models will fall apart if you exploit them
for policy, or push on them, though they may well hold as robust correlations in the data. The

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“consumption function” is the next great example. Keynesians noticed that when income rises people
consume more, so write a consumption function relating consumption to income. But, following
Friedman’s great work   on consumption, we know that correlation isn’t always true in the data. The
relation between consumption and income is different across countries (about one for one) than it is over
time (less than one for one). And we understand that with Friedman’s theory: People, trying to do their
best over their whole lives don’t follow mechanical rules. If they know income will fall in the future, they
consume a lot less today, no matter what today’s current income. Lucas showed that people who behave
this sensible way will follow a Keynesian consumption function, given the properties of income overt the
business cycle. You will see a Keynesian consumption function. Econometric estimates and tests will
verify a Keynesian consumption function. Yet if you use the model to change policies, the consumption
function will evaporate. 

This paper is devastating. Large scale Keynesian models had already been constructed, and used for
forecasting and policy simulation. It’s natural. The model says, given a set of policies (money supply,
interest rates, taxes, spending) and other shocks, here is where the economy goes. Well, then, try
different policies and find ones that lead to better outcomes. Bob shows the models are totally useless for
that effort. If the policy changes, the model will change. Bob also showed that this was happening in real
time. Supposedly stable parameters drifted around. (This one is also very simple mathematically. You can
see the point instantly. Bob always uses the minimum math necessary. If other papers are harder, that’s
by necessity not bravado.) 

This devastation is sad in a way. Economics moved to analyzing policies in much simpler, more
theoretically grounded, but less realistic models. Washington policy analysis sort of gave up. The big
models lumber on, the Fred’s FRBUS for example, but nobody takes the policy predictions that seriously.
And they don’t even forecast very well. For example, in the 2008 stimulus, the CEA was reduced to
assuming a back of the envelope 1.5 multiplier, this 40 years after the first large scale policy models were
constructed. Bob always praised the effort of the last generation of Keynesians to write explicit
quantitative models, to fit them to data, and to make numerical predictions of various policies. He hoped
to improve that effort. It didn’t work out that way, but not by intention. 

This affair explains a lot of why economists flocked to the general equilibrium camp. Behavioral
relationships, like what fraction of an extra dollar of income you consume, are not stable over time or as
policy changes. But one hopes that preferences, — how impatient you are, how much you are willing to
save more to get a better rate of return — and technology — how much a firm can produce with given
capital and labor — do not change when policy changes. So, write models for policy evaluation at the
level of preferences and technology, with people and companies at the base, not from behavioral
relationships that are just correlations. 

Another deep change: Once you start thinking about macroeconomics as intertemporal economics — the
economics that results from people who make decisions about how to consume over time, businesses
make decisions about how to produce this year and next — and once you see that their expectations of
what will happen next year, and what policies will be in place next year are crucial, you have to think of
policy in terms of rules, and regimes, not isolated decisions. 

The Fed often asks economists for advice, “should we raise the funds rate?” Post Lucas
macroeconomists answer that this isn’t a well posed question. It’s like saying “should we cry wolf?” The

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right question is, should we start to follow a rule, a regime, should we create an institution, that regularly
and reliably raises interest rates in a situation like the current one? Decisions do not live in isolation. They
create expectations and reputations. Needless to say, this fundamental reality has not soaked in to policy
institutions. And that answer (which I have tried at Fed advisory meetings) leads to glazed eyes. John
Taylor’s rule has been making progress for 30 years trying to bridge that conceptual gap, with some
success.  

This was, and remains, extraordinarily contentious. 50 years later, Alan Blinder’s book, supposedly about
policy, is really one long snark about how terrible Lucas and his followers are, and how we should go
back to the Keynesian models of the 1960s. 

Some of that contention comes back to basic philosophy.  The program applies standard
microeconomics: derive people’s behaviors as the best thing they can do given their circumstances. If
people pick the best combination of apples and bananas when they shop, then also describe
consumption today vs. tomorrow as the best they can do given interest rates. But a lot of economics
doesn’t like this “rational actor” assumption. It’s not written in stone, but it has been extraordinarily
successful. And it imposes a lot of discipline. There are a thousand arbitrary ways to be irrational.
 Somehow though, a large set of economists are happy to write down that people pick fruit baskets
optimally, but don’t apply the same rationality to decisions over time, or in how they think about the
future. 

But “rational expectations” is really just a humility condition. It says, don’t write models in which the
predictions of the model are different from the expectations in the model. If you do, if your model is right,
people will read the model and catch on, and the model won’t work anymore. Don’t assume you
economist (or Fed chair) are so much less behavioral than the people in your model. Don’t base policy on
an attempt to fool the little peasants over and over again. It does not say that people are big super
rational calculating machines. It just says that they eventually catch on. 

Some of the contentiousness is also understandable by career concerns. Many people had said “we
should do macro seriously like general equilibrium.” But it isn’t easy to do. Bob had to teach himself, and
get the rest of us to learn, a range of new mathematical  and modeling tools to be able to write down
interesting general equilibrium models. A 1970 Keynesian can live just knowing how to solve simple
systems of linear equations, and run regressions.  To follow Bob and the rational expectations crowd, you
had to learn linear time-series statistics, dynamic programming, and general equilibrium math. Bob once
described how tough the year was that it took him to learn functional analysis and dynamic programming.
The models themselves consisted of a mathematically hard set of constructions. The older generation
either needed to completely retool, fade away, or fight the revolution. 

Some good summary words: Bob’s economics uses"rational expectations,” or at least forward-looking
and model-consistent expectations. Economics becomes “intertemporal," not “static” (one year at a time).
Economics is “stochastic” as well as “dynamic,” we can treat uncertainty over time, not just economies in
which everyone knows the future perfectly. It applies “general equilibrium" to macroeconomics. 

And I’ve just gotten to the beginning of the 1970s. 

When I got to Chicago in the 1980s, there was a feeling of “well, you just missed the party.” But it wasn’t
true. The 1980s as well were a golden age. The early rational expectations work was done, and the

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following real business cycles were the rage in macro. But Bob’s dynamic programming, general
equilibrium tool kit was on a rampage all over dynamic economics. The money workshop was one
creative use of dynamic programs and interetempboral tools after another one, ranging from taxes to Thai
villages (Townsend). 

I’ll mention two. Bob’s consumption model is at the foundation of modern asset pricing. Bob parachuted
in, made the seminal contribution, and then left finance for other pursuits. The issue at the time was how
to generalize the capital asset pricing model. Economists understood that some stocks pay higher returns
than others, and that they must do so to compensate for risk. The understood that the risk is, in general
terms, that the stock falls in some sense of bad times. But how to measure “bad times?” The CAPM uses
the market, other models use somewhat nebulous other portfolios. Bob showed us that at least in the
purest theory, that stocks must pay higher average returns if they fall when consumption falls. (Breeden
also constructed a consumption model in parallel, but without this “endowment economy” aspect of
Bob’s) This is the purest most general theory, and all the others are (useful) specializations. My asset
pricing book follows. 

The genius here was to turn it all around. Finance had sensibly built up from portfolio theory, like supply
and demand: Given returns, what stocks do you buy, and how much to you save vs. consume? Then,
markets have to clear find the stock prices, and thus returns, given which people will buy exactly the
amount that’s for sale and consume what is produced. That’s hard. (Technically, finding the vector of
prices that clears markets is hard. Yes, N equations in N unknowns, but they’re nonlinear and N is big.)  

Bob instead imagined that consumption is fixed at each moment in time, like a desert island  in which so
many coconuts fall each day and you can't store them or plant them. Then, you can just read prices from
people’s preferences. This gives the same answer as if the consumption you assume is fixed had derived
from a complex production economy. You don’t have to solve for prices that equate supply and demand.
Brilliantly, though prices cause consumption to individual people, consumption causes prices in
aggregate. This is part of Bob’s contribution to the hard business of actually computing quantitative
models in the stochastic dynamic general equilibrium tradition. 

Bob, with Nancy Stokey also took the new tools to the theory of taxation. (Bob Barro also was a founder
of this effort in the late 1980s.) You can see the opportunity: we just learned how to handle dynamic
(overt time, expectations of tomorrow matter to what you do today) stochastic (but there is uncertainty
about what will happen tomorrow) economics (people make explicit optimizing decisions) for macro. How
about taking that same approach to taxes? The field of dynamic public finance is born. Bob and Nancy,
like Barro, show that it’s a good idea for governments to borrow and then repay, so as to spread the pain
of taxes evenly over time. But not always. When a big crisis comes, it is useful to execute a “state
contingent default.” The big tension of Lucas-Stokey (and now, all) dynamic public finance: You don’t
want any capital taxes for the incentive effects. If you tax capital, people invest less, and you just get less
capital. But once people have invested, a capital tax grabs revenue for the government with no economic
distortion. Well, that is, if you can persuade them you’ll never do it again. (Do you see expectations,
reputations, rules, regimes, wolves in how we think of policy?) Lucas and Stoney say, do it only very
rarely to balance the disincentive of a bad reputation with the need to raise revenue in once a century
calamities. 

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Bob went on, of course, to be one of the founders of modern growth theory. I always felt he deserved a
second Nobel for this work. He’s absolutely right. Once you look at growth, it’s hard to think about
anything else. The average Indian lives on $2,000 per year. The average American, $60,000. That was
$15,000 in 1950. Nothing else comes close. I only work on money and inflation because that’s where I
think I have answers. For us mortals, good research proceeds where you think you have an answer, not
necessarily from working on Big Questions. 

Bob brilliantly put together basic facts and theory to arrive at the current breakthrough. Once you get out
of the way, growth does not come from more capital, or even more efficiency. It comes from more and
better ideas. I remember being awed by his first work for cutting through the morass and assembling the
facts that only look salient in retrospect. A key one: Interest rates in poor countries are not much higher
than they are in rich countries. Poor countries have lots of workers, but little capital. Why isn’t the return
on scarce capital enormous, with interest rates in the hundreds of percent, to attract more capital to poor
countries? Well, you sort of know the answer, that capital is not productive in those countries.
 Productivity is low, meaning those countries don't make use of better ideas on how to organize
production.  

Ideas too are produced by economics, but, as Paul Romer crystallized, they are fundamentally different
from other goods. If I produce an idea, you can use it without hurting my use of it. Yes, you might drive
down the monopoly profits I gain from my intellectual property. But if you use my Pizza recipe, that’s not
like using my car. I can still make Pizza, where if you use my car I can’t go anywhere. Thus, the usual
free market presumption that we will produce enough ideas is false. (Don’t jump too quickly to advocate
government subsides for ideas. You have to find the right ideas, and governments aren’t necessarily
good at subsidizing that search.) And the presumption that intellectual property should be preserved
forever is also false. Once produced it is socially optimal for everyone to use it. 

I won’t go on. It’s enough to say that Bob was as central to the creation of idea-based growth theory,
which dominates today, as he was to general equilibrium macro, which also dominates today.

Bob is an underrated empiricist. Bob's work on the size distribution of firms (great tweet summary by Luis
Garicano) similarly starts from basic facts of the size distribution of firms and the lack of relationship
between size and growth rates. It's interesting how we can go on for years with detailed econometric
estimates of models that don't get basic facts right. I loved Bob's paper on money demand for the
Carnegie Rochester conference series. An immense literature had tried to estimate money demand
functions with dynamics, and was pretty confusing. It made a basic mistake, by looking at first differences
rather than levels and thereby isolating the noise and drowning out the signal. Bob made a few plots,
basically rediscovered cointegration all on his own, and made sense of it all. And don't forget the classic
international comparison of inflation-output relations. Countries with volatile inflation have less Phillips
curve tradeoff, just as his islands model featuring confusion between relative prices and the price level
predicts. 

One last note to young scholars. There is a tendency today to value people by the number of papers they
produce, and how quickly they rise through the ranks. Read Bob’s CV. He wrote about one paper a year,
starting quite late in life. But, as Aesop said, they were lions. In his Nobel prize speech, Bob also passed
on that he and his Nobel-winning generation at Chicago always felt they were in some backwater, where
the high prestige stuff was going on at Harvard and MIT. You never know when it might be a golden age.

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And the AER rejected his islands paper (as well as Akerlof's lemons). If you know it's good, revise and try
again. 

I will miss his brilliant papers as much as his generous personality. 

Update: See Ivan Werning's excellent "Lucas Miracles" for an appreciation by a real theorist. 

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