Wednesday, May 17, 2023

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 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 “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 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 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. 

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. 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. 


  1. About three decades ago, Professor Lucas taught Economics 101 (or it could have be 102) to undergraduates at the University of Chicago. The average class size was in the low teens because students were intimidated by him. He was known at that time to be on the short list for the Nobel Prize, and he was also known to grade very strictly, so it was possible to fail his class (which is probably impossible in most college classes today). However, he also made a deal with his students: if you were able to score an A in his class, he would write you a letter of recommendation for graduate school. As luck would have it, I was one of the students who was able to score an A in his class.

    I was able to get a copy of his letter of recommendation. It was a form letter that was a recitation of many of the papers and accomplishments of Professor Lucas. At the bottom, it summarized the difficulties and challenges of his economic course, and the fact that only a tiny percentage of students ever achieved an A in it. In the blank at the bottom of the page, my name was entered with Professor Lucas's endorsement that any student who gets an A in his class would excel in any graduate program in the country.

    I applied to the top 10 law schools in the country with his letter of recommendation, and I was accepted to all 10. I am eternally grateful for the chance to take Professor Lucas's class, and the opportunities he opened up for me.

    1. Wow, way to make the subject all about your achievements

  2. "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."

    Bob and Nancy, like Barro (and all the way back to Andrew Mellon and Hamilton before him) know only one type of government deficit finance - war bond sales.

    The reason that the US government finances deficits exclusively with war bonds is all about the incentives. A government (especially one that institutes a draft or conscription) will need to guarantee the returns on investment (interest payments) to prospective buyers that may also be conscripted into military service.

    Would you buy anything else from a government when you might be killed or wounded, reducing your ability to return to your regular job once a war is over?

    It has nothing to do with "spreading the pain" of taxes over time.

    If a government was worried about "the pain" of taxes exclusively, they would be selling tax breaks instead of bonds and they would be selling them on demand regardless of deficit or surplus.

  3. The essay above gives a taste of the brilliance of Robert E. Lucas, Jr. Delving into his published works requires of the inquirer the courage of an explorer of new worlds along with an open inquisitive analytical mind. The following article is just one such adventure into the vast unknown to the uninitiated. One cannot help but wonder if the writers of papers pertaining to macro-economics today who claim that their models are founded on 'micro-economic foundations' and the 'Lucas critique', are being honest with their readers?

    Excerpts from the penultimate and ultimate paragraphs of the paper:
    “The argument is, in part, destructive: the ability to forecast the consequences of "arbitrary", unannounced sequences of policy decisions, currently claimed (at least implicitly) by the theory of economic policy, appears to be beyond the capability not only of the current-generation models, but of conceivable future models as well. On the other hand, as the consumption example shows, conditional forecasting under the alternative structure (16) and (17) is, while scientifically more demanding, entirely operational.
    “In short, it appears that policy makers, if they wish to forecast the response of citizens, must take the latter into their confidence. This conclusion, if ill-suited to current econometric practice, seems to accord well with a preference for democratic decision making.”

    The reference to equations (16) and (17) in the paper refer to the following passage
    "As observed in section 4, one cannot meaningfully discuss optimal decisions of agents under arbitrary sequences {x_t} of future shocks. As an alternative characterization, then, let policies and other disturbances be viewed as stochastically disturbed functions of the state of the system, or (parametrically)
    (16) xₜ = G( yₜ , λ , ηₜ )
    where G is known, λ is a fixed parameter vector, and ηₜ a vector of disturbances. Then the remainder of the economy follows
    (17) yₜ₊₁ = F( yₜ , xₜ , θ(λ), eₜ )
    where, as indicated, the behavioral parameters θ(λ) vary systematically with the parameters λ governing policy and other "shocks". The econometric problem in this context is that of estimating the function θ(λ)."

    xₜ represents the exogenous variables in the model.
    yₜ₊₁ represents the endogenous variables in the model.

  4. Professor Cochrane, thank you for this post. I was deeply affected by Lucas' passion. Although I am not a Chicago or Minnesota Ph.D., my economic upbringing was heavily influenced by the Chicago and Minnesota traditions. Everything I learned in macro in graduate school revolved around dynamic programming and DSGE. One of the books I love the most is SLP's Recursive Methods in Economic Dynamics -- When my son was born, I wrapped him with SLP's flap cover -- Yet, after close to 20 years working as a quant portfolio manager on Wall St, I struggle finding practical value in general equilibrium macro. I appreciate the mathematical beauty and equilibrium properties. But besides the rigor to postulate an idea or to think about a problem, all the asymptotic results and convergence properties of equilibrium do not help me beyond saying that this or that will happen asymptotically, knowing we will never reach such point. Financial markets and economies are inherently unstable and not suitable to be characterized by some kind of equilibrium. Long-term relationships are not useful when I am interested in surviving the next quarter. In that sense, perhaps without the mathematical elegance, I find Keynes' (not the Keynesian) approach more useful and compelling. (Keynes was a very successful macro hedge funder.) We cannot pretend to know or that there exists a relationship between two or more variables. Even those we find occasionally are ephemeral in my line of work. I think that at a practical level, intellectual freedom and adaptability are more useful than the rigidity of laws of motion and equilibrium relationships. I am not saying the latter are useless; in fact, perhaps the academic rigor from graduate school is necessary to develop the adaptability we need on the street. I hope you can appreciate my struggle.

  5. Keynes said that statistical relations among variables were not stable, classifying economics as a moral science. That is, he anticipated the so-called "Lucas Critique", but knowbody knows it. Pity,

  6. In my time, Bob taught one of the three courses in the first year Macro PhD sequence. The first day, he walked in clearly very angry---he seemed to have just finished arguing with someone, or reading something that really annoyed him. We were expecting the typical overview of the course, the reading list etc… Instead, we got a monologue I can still remember more than three decades later. In short, what he told us was that the job of an economist is not to provide politicians with a menu of policy prescriptions that he or she could choose between, to best accomplish their political objectives. Instead, the job of an economist is to tell the politicians what the right policy is, whether or not it is politically palatable---it is their job to figure out how to enact it.

    May his memory be a blessing. יהי זכרו ברוך

  7. In my time, Bob taught one of the three courses in the first year Macro PhD sequence. The first day, he walked in clearly very angry---he seemed to have just finished arguing with someone, or reading something that really annoyed him. We were expecting the typical overview of the course, the reading list etc… Instead, we got a monologue I can still remember more than three decades later. In short, what he told us was that the job of an economist is not to provide politicians with a menu of policy prescriptions that he or she could choose between, to best accomplish their political objectives. Instead, the job of an economist is to tell the politicians what the right policy is, whether or not it is politically palatable---it is their job to figure out how to enact it.

    May his memory be a blessing. יהי זכרו ברוך

  8. In reading about Prof Lucas I am struck by one thing that puts him head and shoulders above most in the economics profession: He got that story is a more important variable than numbers from which story derive. Not getting the story right means the model/numbers will have substantive shortcomings. Too many in the economics profession are wizards with numbers, but too many seem to miss the importance of a well thought out story which then numbers are applied to with some sensitivities applied to the outcomes as all things are probable. Perhaps more economists need to better understand history, psychology and maybe even literature a bit better.

  9. A nice summary, but what do you mean by the parenthetical remark that "we don’t do money supply any more"? Analysts who were paying attention to money supply measures correctly anticipated that U.S. inflation would rise in 2021, would be well above the Fed's 2% target, and would not be merely "transitory."

    1. The Fed targets interest rates and does not control monetary aggregates. Money demand is entirely accommodated. It can be a leading indicator, tough it produces many false signals for every correct one, but not a cause. Do you think that the same inflation would have resulted if M2 had risen, but there had been no deficit? The central tenet of monetarism is that higher money causes the same inflation whether financing a deficit, or if the government issues money and takes back bonds. Not so obvious!

    2. And 'the corn price of gold' in Spain during the height of bullion imports from its American colonies? Bob Lucas seemed to agree with David Hume's observations on the quantity theory, but noted that Hume's mathematics wasn't up to the task. Your observation hinges on a fiat currency effect wherein the central bank plays a key role in monetizing the government's deficit spending. One large issue is the definition of 'inflation' -- there is a measurement issue present (or, as control engineers say, an 'observation issue'--the true measure is not observed by the system controller/economic planner).

      An interest rate that is higher than the interest rate paid in international markets will pull money into a country and prompt an increase in consumption that lifts prices, as is well-known in international finance. We don't find that effect in NK DSGE models because those models are narrowly focused on small perturbations from a steady state equilibrium in order to achieve a mathematically tractable linear solution. All other effects are assumed away.

      Aerodynamics is nonlinear, but relies on perturbation theory to make the mathematics linear and thereby tractable. But it doesn't stop there -- it relies on the method of successive approximations to achieve workable designs for aircraft and wind turbines and towed gliders. NK DSGE economic modellers might usefully learn something from aerodynamicists, someday.

    3. People, like Powell and Hanke, who speak of M2, know little about money and central banking. Money flows, the volume and velocity of means-of-payment money, hit historical highs in November 2020. N-gDp subsequently exceeded all norms. Inflation followed. It was no happenstance. Nothing's change in a century.

    4. Nominal GDP, Y(t), and the rate of inflation, pi(t), are related through the following definitions:
      (i) log(Y(t)) - log(P(t)) = log(y(t)) , where P(t) is the price index and y(t) is real GDP; and,
      (ii) d(log(P(t)))/dt = pi(t). Equation (ii) gives the definition of the rate of inflation.

      Combining (i) and (ii) gives
      (iii) d(log(Y(t))) - d(log(y(t))) = d(log(P(t))) = pi(t) dt.
      If we know two of the three measures, then the third, e.g., Y(t), is redundant.

      The FRB's dual-mandate requires (a) price stability, and (b) full employment. Price stability requires that Y(t) = y(t), i.e., it requires that nominal GDP be equal to real GDP. From (iii), price stability implies that d(log(Y(t)))/dt = d(log(y(t)))/dt +/- eY(t), where eY(t) is a tolerance.

      Full employment means that the output gap, x(t) is 0 +/- eX(t), where eX(t) is another tolerance.

      The FRB, however, defines 'price stability' to be pi(t) = pi*(t), the so-called target rate of inflation. From (iii), this implies that
      (iv) d(log(Y(t))) - d(log(y(t))) = pi*(t) dt. And, from the NK-DSGE 2-equation model, that X(t) > 0,
      where X(t) = log(y(t)) - log(y+(t)) and y+(t) is the ideal frictionless real GDP at time t. X(t) becomes positive when the business planner's reserve capacity is utilized (i.e., when downtime for maintenance and plant renewal is deferred).

      Hinke, S., is not a 'central banker'. I doubt that he would describe himself as such. Powell, J., is a central banker by occupation; you may, as Williamson, S., did, declare that he was not qualified to be chairman of the FRB at the time of his appointment (he lacks a Ph.D. in economics), but there is no question that he is filling that position at present. As, Greenspan, A., pointed out, the chairman sets the agenda, but little else--whatever the chairman does accomplish is done via persuasion (i.e., well-reasoned argument). We call this the "weak-chairman" committee type.

  10. I agree with much of the praise for Lucas, but Samuelson is clearly the most influential economist of the 20th century. He revolutionized all of economics. Find a topic where he did not make a seminal contribution.

  11. Professor Cochrane, Could Lucas ideas about economics be summed up in one question, "How do we create the best incentives for abundance?" It seems to me the Keynesians are all about constraints, and limits. They allow economics to become a parlor game where people can argue semantics and not numbers. Policy wonks can enter the fray and you don't really need to understand or be able to execute/comprehend the underlying math to participate. It becomes a case of "fairness" and normative rather than positive economics. The classical school looks at abundance, with it's corresponding negative/positive externalities and quantifies those so you can make a decision.

  12. Thanks John for this post. Even as somebody with econ PhD and who read most of the papers, I found the historical context extremely useful. Makes me feel like we should really have academic articles like this, so that this kind of knowledge is preserved from generation to generation.

  13. "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. "

    what book are you talking about?

    1. "A Monetary and Fiscal History of the United States, 1961–2021" by Alan Blinder, published in October 2022, Princeton University Press.
      ISBN-10: ‎ 0691238383
      ISBN-13: ‎ 978-0691238388

  14. Small comment re taxes:

    Anything you tax, you'll get less of.

    Taxing productivity makes people less productive. Taxing consumption makes people frugal. Taxing property makes people devlop less. Taxing land makes people....something.

    The proper way to decide between different revenue models for a government is not to compare a form of tax vs. no tax, it's to weigh that form of tax against other forms of tax.

    When pushing for consumption tax, simply compare different areas with different consumption tax rates, and see which areas are better financed, have higher quality of life (measures in land values) and which areas have less variance of wealth in the cross section (a measure of more optimal distribution of a fixed amount of wealth.)

  15. Lucas did a few more amazing things. His paper(s) with Atkeson reformulated the question of Pareto optimal allocations from a GE point of view, where they close the economies studied by Green and Thomas and Worrall. As it turns out, their price formulation of the problem brings an entirely new perspective to the question.

    Another important contribution of his is the paper on "Optimal Cities" with Rossi-Hansberg looks the question of what is an optimal city from a GE point of view. Again, Lucas brings his expertise in formulating the problem from a GE point of view, while still maintaining tractability.

    As noted by John, his skill was in problem formulation. Which itself brings with it a unique set of insights. Of course, he showed us how to solve these problems too, but the sheer breadth of his research showed that this is a well that is well-nigh inexhaustible. And he went to it over and over again, with nary a drop in return.


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