The Common Man Has Economic Clout
IF a mother tells her son that he better not poke his little sister again, or he will be spanked, and then he does it and she doesn't spank, the mother loses some credibility. If mom does that a few times, the boy isn't likely to believe future threats.
This lad has a "rational expectation,'' and it is "rational expectations" applied to economic theory that this week won Robert Lucas Jr. the 1995 Nobel Memorial Prize in Economic Science with its $1 million award.
Dr. Lucas, a professor of economics at the University of Chicago, is an economists' economist. He doesn't write for the general public. Yet, he not only has had a "profound effect" on other economists but also on economic policymakers, notes Allan Meltzer, an economist at Pittsburgh's Carnegie-Mellon University, the school where Lucas did his prizewinning work in 1972.
In the specialized language of economists used by Lucas, "there obtains a class of stochastic neutrality propositions that imply severely limited possibilities for engaging in successful activist countercyclical policy."
In layman's terms, the common man often can foil government efforts to control the economy. Like the boy, individuals, households, and companies soon figure out that government economic threats and promises are not being implemented and act according to rational expectations and self-interest.
Say the Federal Reserve promises tight money to bring down inflation, but it doesn't actually cut growth in the nation's money supply. The financial community and consumers may be fooled the first time, and interest rates may fall briefly as investors expect a slowdown. But prices will rise anyway and fewer people will be fooled the second time the Fed tries this. As a result of this new awareness of the importance of expectations, the Fed today shows greater concern with the credibility of its anti-inflation policy than did some earlier Fed administrations.
"The Federal Reserve is paying much more attention to price stability than it used to,'' says Paul Romer, an economist at the University of California at Berkeley. "It is taking a much longer view than it did in the 1970s."
Similarly, some West European nations have 9 percent or more unemployment. Yet central bankers there are not trying to pump up the economy. They figure such an effort would be counterproductive. The public would interpret a sudden drop in interest rates and faster money growth as an inflationary move. So they would raise prices now, not in the future, eating up that new money and thus not giving the economy much of a boost. The central bankers would be left with a worse situation - higher inflation that must be constrained by a new tighter money policy.
Of course, the idea that people act according to expectations is not new. What Lucas did, explains Dr. Meltzer, is take a framework for the economy that economists have used for generations, the "Walrasian general equilibrium analysis," and turn this sterile accounting framework into a dynamic framework. It takes into account the feedback of rational expectations.
This work had an intellectual appeal to economists. "It is difficult to pick up a paper in macroeconomics [the big economic picture] which doesn't have some reference to Lucas's work," Meltzer says. The work also gave an analytical framework to the findings of another Nobel prizewinner, Milton Friedman, and to Meltzer's own work, on the importance of monetary stability to price stability. And Lucas devalued the view popular in the 1960s and 1970s that government could "fine tune" the economy.
"There is an increased appreciation that you can't make people rich by turning on the [money] printing presses," Mr. Romer says. Nonetheless, many economists see a role for government in the economy. For example, Alan Krueger, who returned to Princeton University this summer from being chief economist in the Labor Department, says government can promote job training and education that lead to a more productive economy. "A lot of government expenditures have an investment role," he says.
Romer offers his "new growth theory." It argues that support for technological progress through assistance to universities and encouragement of innovation and research can stimulate growth. Moreover, he says, government has a role in avoiding economic catastrophe: not causing depression with wild monetary policy.