Is what we expect tomorrow affecting the economy today?

When you’re deciding to buy a house, a car, or to put your child through college, you’re thinking ahead. You’re wondering whether the price of the house or the car will go up or down; whether the child that goes to college will get a job. Your considerations influence the decisions you end up making. There’s nothing new or surprising about it. Yet, this seemingly common wisdom wasn’t a part of economic modeling until the work of Bob Lucas. As Lucas’ colleagues refer to it, "There’d been a before and an after Lucas." 

Robert E. Lucas

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (shared), 1995

At a glance

Born: 1937, Washington, USA

Field: Macroeconomics

Prize-winning work: Development of the Rational Expectations Theory in macroeconomic analysis

Sports: Avid fan of the Chicago Cubs baseball team

Pictured in his office: His 21-year-old cat

Books on his nightstand: Fiction he feels comfortable with, sometimes re-reading old classics like Tolstoy or Joyce

Way to stay fit: Regular gym visits

Before and after Bob Lucas

It’s also not surprising that the Nobel Committee acknowledged Lucas’ work as the one that marks a clear watershed of before and after in the way macroeconomic analysis is done. While many contributions to economics, from policy analysis to finance to economic growth, come under Lucas’ name, there is one that stands out. It’s his 1972 paper “Expectations and the Neutrality of Money” that inspired a host of contributions and left a legacy unlike any other. Macroeconomic models now include the effect that future earnings and spending have on today’s decisions.

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What Lucas did was to take an idea of rational expectations, seemingly no more than common sense, and model it mathematically. Mathematics lies at the core of how he thinks about the world and things that matter to him. His workflow roughly goes as follows: first Lucas invents a fictional world, very similar to fiction writers, and works out mathematically how would this world operates under various circumstances. Second, he tries to see if there are analogies between the real world and this fictional world of mathematical modeling. "If we were to describe people’s behavior," the economist emphasizes, "we want our models to actually line up with what we’re doing. And Rational Expectations is a way to do that."

Indeed, economics for Lucas "is about people and how they decide what to do. Anything that happens in the economy happens because people do this or that or something else. And if we’re trying to understand that, we have to get inside those people and ask what they’re thinking. And the rational expectations answer is: they’re thinking what they should be thinking. If they’re making a forecast they’re probably doing it well. People kind of know their own business better than outsiders like economists do. And we want to try and get into that."

Zooming into people’s lives, and zooming out to models

How is it that people and their decisions remain the focus of a rather abstract macroeconomics analysis in Lucas’ work? The answer reveals itself throughout the conversation at his short-let 6th Avenue apartment overlooking New York City. As if visually supporting the subject of our conversation, the cars and pedestrians appear smaller and less relevant than they actually are in the bigger context of the city.

As a former student of history who’d been inspired by Karl Marx and Friedrich Engels’ 1848 The Communist Manifesto, he is profoundly interested in understanding "just how ordinary people live, how they work, what they do, what they know". And in economics, his vision dictates, "You’ve got to take people as they are and not as you might wish they were, you’ve got to make it real." He reveals the tension between trying to understand individual behavior and grasping the workings of an economy as a whole by confessing: "We’re trying to describe a whole economy through 300 million people in six or eight equations; that’s abstraction. There’s no question about that."

How do you keep it simple when modeling an entire economy?

Keeping it simple and close to reality is how mathematical modeling approximates the laboratory conditions in economic science. Former student and colleague Francisco Buera of the Federal Reserve Bank of Chicago related that one of the most important things about Lucas is that he was "the person who pushed very strongly for economists to develop mathematical models that can be used as laboratories. It’s important because you don’t want to use people’s lives as laboratories." Playing around with the policies in models, like raising taxes or subsidizing industries, doesn’t put people’s lives in danger. When successful, Lucas suggests that the insights gleaned from models can be implemented in the real world. These connections through mathematics are not simply a given; they’re something carefully constructed by economists.

So then, how do you keep it simple when modeling an entire economy? In his gentlemanly manner, Lucas suggests that getting down to something simple and practical is easier said than done. "The whole point of macroeconomics is to simplify on a couple of things and not get lost in the details," he says as he describes the foundation of his and other economists’ work. "So we often talk about people as though everybody is acting exactly the same way for exactly the same reasons. There’s no such thing, obviously. But there’s no point in setting out complicated theories when you can’t work out their consequences. So complication is the enemy."

"I haven’t hit Newton’s level, I know," the economist modestly consents. "But when Newton looked at the Earth going around the sun, he neglected all the other planets because he couldn’t handle all ten planets. He figured he’d get pretty close, which of course he did. That’s how you do it: you start with something simple and develop it as far as you can."

Obviously, we’re dealing with a true master of abstraction and simplification. Lucas’ colleague Andrew Caplin at NYU, where he often visits as a guest, elegantly confirms this: "Bob’s models reveal that he has a very unusual mastery of how to tell a story as simply as possible to contain the essence of the situation. He’s doing the simplest thing you could possibly do that wasn’t ridiculous."

Seeing the world through discussing ideas

While Chicago is definitely "the only home I got," being at NYU is an intellectual treat for Lucas. "It’s stimulating to be here," the economist reveals. "At any place you work, you tend to have the same conversations over and over again after a while. Even if the people are smart and interesting. A place like NYU, it’s just an eye-opener: to talk to people who are smart, and doing good work I’ve never seen before. Something that’s really new and novel. It’s very useful, it’s good to get out to see the world. And NYU is a great place for that."

As we see him off at Grand Central Station to catch his train to a conference in Philadelphia, Lucas opens up even more about what’s important to him in life, apart from the great thrill of economics. Socially, what matters to him is having a regular exchange of ideas with people who are similarly driven.

You want to hang around with idealistic people. People who really want the truth, who help you. You want to have people around who really care about what they’re doing and I’ve had great luck with that.

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What does Lucas’ work mean for us?

"Lucas argued that, until you understood why two variables are connected, you don’t really understand anything at all."

Tim Harford
Financial Times columnist and author of The Undercover Economist

"Lucas was someone who embodied the economic challenge, giving his name to the Lucas Critique."

Paul Donovan
Global Chief Economist
UBS Wealth Management

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