The Newton and Einstein of Economics: Keynes vs. Lucas

When the facts change, I alter my conclusion.” as put forth by John Maynard Keynes, the man whose economic insight helped shape our modern economic landscape.

Later in time, this notion that facts change (i.e. that the economy is dynamic) was adopted widely, but oddly enough, Keynes was not the one who popularized the idea. Before the mid 1970s, Keynesian Economics was employed to supposedly steer the economy in the right direction. The practice was dominant in many of western nations (and only later on spread to the east). However, Keynesian economics (despite what Keynes famously said) treated many economic relationships like the relationship between inflation and unemployment (illustrated by the Phillips Curve) as stable/fixed.

In a way, this is no different from how Isaac Newton thought that space and time are static, that together they merely act as a stage where all the actions happen. Only a few centuries after, that Einstein came in to correct this misconception and to show the world that space and time are NOT static and that they can bend just like fabric; hence, the General Theory of Relativity. This new discovery brought upheaval to the entire field of theoretical physics.

left portrait: John Maynard Keynes, right portrait: Robert Lucas Jr.

Similarly, in economics, another prominent economist, Robert Lucas Jr., was the one who challenged the then dominant Keynesian foundations of macroeconomic theory and developed the new classical macroeconomic theory using microeconomics as its foundations. “Lucas Critique” was indeed a crucial turn of event in the field of macroeconomics and economics as a whole.

To elucidate the idea, let me give you an example of the difference between macroeconomic model then and now. Before “Lucas Critique”, some of the most important variables in an economic model were treated as exogenous (given or another way to put it: god sent). For instance, a model might depend heavily on the rate of private saving, and this number, private saving rate, is plugged into the model based on the past economic observation/data. This does provide useful information about the current economic climate, but only to an extent. However, the fatal flaws, the inaccuracy and impracticality usually arise when economists want to run economic simulation or forecast of the economic outcomes due to some new policies to be promulgated. Why? Be patient. Read on.

Lucas introduced the idea of “Rational Expectation“, that is economic agents (consumers, producers, government, investors, etc) are rational and will form anticipation of the future based on the information available today. In that sense, past data helps little. Think about it. If the government increases spending and lowers tax today, the economic agents will expect the fiscal policy to be tightened in the future (i.e. higher tomorrow tax and lower tomorrow spending to offset the over-spending or budget deficit today). So, consumers might consume less today and save more to prepare for higher tax in the upcoming years. Other agents like producers and investors will re-optimize and thus change their behaviors accordingly. When behaviors of the agents change, the economic parameters presumed static at the beginning are NO longer static. In the long-run, the overall effect of such expansionary policy is either naught or unpredictable if static models are used. Even if a static model has predictive power, it tends to be small (i.e. comes with a large degree of errors) and cannot be generalized. Of course, you might argue that not everyone changes his behavior or forms rational anticipation of future changes, but this theory of rational expectation only needs to work on average. Plus, greater proportion of educated population will give rise to this scenario.

This keen perception of how the economy progresses and behaves earned Lucas a place in the economic Hall of Fame. He got his Nobel Prize. Good for him. Macroeconomic models were also changed drastically after in order to include, for instance, endogenous saving (that is “saving rate” that can be explained within the model). To do that, macroeconomic models are turned into aggregated microeconomic models. In other words, economists incorporate micro-economic models that either look at different markets or different groups of agents (government, household, producer, etc) and merge them into a single coherent whole to explain various macroeconomic events. Simply put, we now build models within models (and so forth) within a model. For instance, saving rate can be explained by the utility maximizing desire of consumers who have to allocate consumptions across time and state. It makes sense actually. That is why you buy insurance to smooth consumption over different states (healthy state, sick state, having baby state, car accident state, etc) at the cost of future saving and present consumption that also add to your utility. That is why you put money into saving account to maximize your future purchasing power. All these happen in a micro-model (that is later affixed to the grander macro model), and thus, private saving decision (saving rate) can be explained inside the model (without having to rely completely on static past data), all because of one economic assumption: that you are a utility maximizing consumer. Of course, similar models can be built for government, investors, producers and many other economic agents. Remember, these are the basic forms. There are more complicated ones I did not mention. For example, if you make a model with liquidity preference in it (i.e. the demand for money as a type of good in itself), then the whole macroeconomic model has to be altered to accommodate the new microeconomic insight.

You see, I just find it strange that Keynes seemed to have perfectly understood the idea of dynamism in economics while the scholars and practitioners that came after him only took his theory at its face value. This is just a sad reminder that an apparently simple theory is not so simple in research and practice, and that economics, even at its more developed form now, is not without flaws. Of course, even the highly regarded micro-founded macroeconomic models we discussed above come with plenty criticism of their own. We leave it for future articles however. The point is economics is a rather young science, and just like in any discipline, there are rooms for improvement. Still, an improvement for the future cannot be made without a clear comprehension of the past. Thus, the video below will serves you well in accomplishing that first task. Enjoy.

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