FISCAL FITNESS - DECEMBER 1995
by Ron Ross
The latest Nobel Prize in economics was awarded to Robert Lucas of the University of Chicago. He is known primarily for his work regarding the concept of rational expectations. The essence of rational expectations could be summarized as "people aren't as dense as policy makers used to think they were."
Lucas showed statistically that the average person anticipates the impact of governmental economic policy. As individuals and businesses anticipate the probable effects of actions by policy makers, they adjust their behavior. As they do so, the effect the policy makers had hoped for is at least partially nullified.
One issue that was illuminated by the insights of Professor Lucas was the so-called Phillips Curve. The initial Phillips Curve data seemed to show a trade-off between unemployment and inflation. One implication was that we ought to tolerate some inflation since it would result in a reduced unemployment.
Lucas and other rational expectations theoreticians showed that the trade-off does not actually exist, especially not in the long-run. Their theory explained the results along these lines: any attempts to stimulate the economy by means of deliberately creating inflation would be transparent.
To illustrate how rational expectations interfere with policy makers' intentions, consider the following: Let's say a government wants to stimulate the economy and decides to do so by dropping money out of helicopters.
People having more money tends to stimulate spending and employment, at least until prices are bid up. Higher prices effectively neutralize the larger money supply. At best, the new money creates only a short-term stimulus.
According to the conclusions of rational expectations, however, there may not be even a short-term economic boost. If decision makers anticipate policy makers' actions, prices will go up at the first sound of helicopter engines. The impact of the increased money supply would be instantaneously nullified.
I remember being at a convention of economists about the time rational expectations was first becoming a hot issue. One of the discussants of a paper asked the paper's author, "Are you talking here about people or economists?" The author replied, "Well, I think one is a subset of the other."
The exchange illustrates a general criticism of rational expectations -- that it seems to imply that ordinary decision makers in the economy think like economists who are closely monitoring and predicting what's in store for the economy. Although rational expectations may seem to imply that, it actually doesn't.
The best test of a theory's validity is its ability to predict. Models taking rational expectations into account predict economic phenomena better than ones that don't.
It's probably true that most people don't think like economists. The evidence, however, indicates that players in the economy are not chumps. Ordinary people do learn from past experience and adjust their behavior accordingly.
From the standpoint of developments in economic theory, the University of Chicago is in a class by itself. Its economics department members have won Nobel Prizes in five of the past six years.
The department is known for its respect and admiration for the workings of the free market. The flip side of that attitude is a skepticism for government solutions to problems.
Lucas' work is definitely consistent with the general themes the department has pursued for 50 years. A major implication of rational expectations is that government policy makers have much less control than they used to believe. If their control instruments are unreliable and unpredictable, the case for intervention loses much of its appeal.
One key to the department's success is its ingenuity in applying basic economic theory to other disciplines. Merton Miller, for example, won the 1990 Nobel prize for his breakthroughs in what has come to be known as "financial economics."
The winner in 1991, Ronald Coase, has been instrumental in applying economic analysis to our legal system. He founded and edited the Journal of Law and Economics.
Lucas has developed theories that assume a higher level of sophistication and awareness on the part of decision makers than did earlier models. He treated people with more respect and was rewarded in at least two ways for doing so. His theory generated more accurate results, and he won the profession's highest honor, the Nobel Prize as well as the $1 million that goes with it.
A former professor of economics, Ron Ross is a financial planner with Premier Financial Group, Eureka.
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