By Prof Satya Narayan Misra in Bhubaneswar, Mayu 20, 2023: The economist who turned John Maynard’s central concept of animal spirits on its head and revolutionized macroeconomics with his concept of rational expectation orphaned his innumerable admirers last week.

Keynes’ magnum opus General Theory published in 1936 debunked the classical theory that supply will create its own demand and any aberration in the economy will self-correct itself. Keynes thumb nailed the importance of public investment & fiscal stimulus during an economic depression; a policy prescription that came in handy during the economic depression of the 1930s.

By 1971 even a diehard conservative like Richard Nixon observed that ‘We are all Keynesians now’, alluding to the importance of fiscal stimulus in a time of financial crisis. Interestingly, Keynes mooted the concept of animal spirits, referring to movements in investment that could not be explained by movements in current variables.

This is where Lucas brought in the concept of rational expectation as in which people optimally use all information; they have including information about government policies when forecasting the future, instead of blindly leaping into the future.

In a 1976 article, he introduced the Lucas critique and incorporated the idea of rational expectation into a dynamic general equilibrium model. He challenged the foundation of the Keynesian economic system arguing that a macroeconomic model should be built as an aggregate version of microeconomic models, while noting that aggregation in the theoretical sense may not be possible within a given model.

One of the major concepts in economics is Phillips Curve in the 1960s as in which there is an inverse relationship between employment and inflation. When stagflation occurred in the 70s, with rising unemployment not coinciding with declining inflation, the role of rational expectation propounded by Lucas proved prescient as workers and consumers adapted their expectations about future inflation rates based on current rates of inflation and unemployment.

Milton Friedman & Phelps showed that the trade-off between unemployment and inflation applies only in the short run and not in the long run when the Philip curve is vertical. Lucas wrote that if an econometric model shows that a 3% drop in inflation would lead to a 2% increase in unemployment, one could not use this correlation to predict the effect of a future 3% drop in inflation, because people’s expectations would not be the same. He and

Thomas Sergent argued that in thinking about the effect of alternative policies, economists should assume that people have rational expectations and that people look into the future and do the best job they can in predicting it.

He believed that neither capital gains nor any of the income from capital gains should be taxed at all. He estimated that eliminating the capital income tax would increase the US capital stock by 35%.

He wrote: The supply side economists have delivered the largest genuinely free lunch that I have seen in 25 years of these businesses. His views were sharply different from Thomas Piketty who strongly argued in favour of global capital tax as the most potent policy tool to reduce sharp and rising income inequality. For Lucas, the goal of tax policy is to usher efficiency & wealth creation rather than equity and social justice as championed by Piketty, Atkinson & Schiedel. He was a libertarian.’

In economic policy, the frontier never changes. The issue is always mercantilism; government intervention vs laissez-faire & free market’, wrote Lucas. In 1979, Lucas gave a talk on ‘The Death of Keynesian Economics’ as he was leading a revival of neoclassical economics where Keynesian thinking was passé. The Chicago school and its students and leading proponents like Lucas and Milton Friedman were called freshwater economists as opposed to saltwater economists like Keynes.

For them, the phenomenon of depression was consigned to the dustbin of history. In his Presidential address to the American Economic Association in 2003 Lucas declared that ‘the central problem of depression- prevention has been solved for all practical purposes. ‘Little realizing that five years later that the great depression can strike the US economy. It was a case of the collapse of aggregate demand, which needed the Keynesian prescription of huge fiscal stimulus and pump priming.

Monetary policy had failed despite zero interest rates. Neither investment nor employment rose as ‘one cannot lead the horse to water unless it is thirsty.’ We are all Keynesians again. Be it the US financial crisis in 2007-2008 or the pandemic from 2019- 2021, it’s the long hands of the government and its fiscal stimulus that has taken countries out of the quagmire of unemployment and demand deficits. Keynes had once wittily observed:

The difficulty does not lie with introducing new ideas but with replacing old ones. Lucas must be credited with a new idea that consumers are not dumb & investors have animal-like spirits but have a rational expectation that has a crucial contribution to how economic systems will pan out. When Lucas and his wife got a divorce in 1988, she negotiated for 50% of the Nobel prize money that he may receive, with October 31, 1995 as the expiration date.

Lucas won the Nobel Prize in Economics on 10th October 1995. Economists joked that Lucas’s model applied to his wife. She had rational expectations! Lucas also sowed the seeds of behavioural economics, which found eloquent exposition in the hands of Daniel Kahneman and Richard Thaler, later day Nobel laureates.

Professor Misra is a Professor Emeritus

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