Models of business cycles

Structural Change and Economic

REVIEW RICHARD

Dynamics,

vol. 3, no. 1, 1992

ARTICLE H.

DAY

Models of Business Cycles. By ROBERT E. LUCAS, JR, (Oxford: 1987. Pp. 120. f10.95 ISBN 0 631 147918)

Basil Blackwell,

Here is the mature statement by an important scholar written at the time of his greatest influence. I know of no one writing now who expresses a motivation of higher practical or scientific purpose, who frames his research program with greater care, who carries it out with greater rigor, or who describes his results in more lucid prose. Here we see the hand of a master craftsman moulding inherited material to his personal vision and so conceived as to inspire the admiration and adherence of a legion of followers. The vision has limits, however, limits so severe as to raise in our minds certain fundamental questions about science and method in our discipline and the application of economic theory to policy. These questions are of central importance in our time and I shall be more specific about them in due course. However, first let us set out briefly the vision and its limits. The book, based on the YrjG Jahnsson Lectures presented in Helsinki in 1985, is divided into eight untitled chapters. The first presents the author’s view of contemporary macroeconomic theory which he regards as having achieved a great advance over its Keynesian origin. This advance has enabled ‘the modern theorist [to study] roblem he wants to study’ and has facilitated the ‘entirely routine exactly the as operating through time in a complex, [analysis of P economic decision-making probabilistic environment, trading a rich array of contingent-claim securities with a wide variety of possible technologies, information structures and stochastic disturbances’. These developments, Lucas argues, should lead to a ‘radically different point of view’ about macroeconomic theory and policy. Most readers will recognize that the shift in point of view has already occurred. Chapter II sets out the basic framework. It employs the dynamic programming mode1 to describe an optima1 intertemporal equilibrium strategy for an economy whose agents have nothing essential to learn, no incentive to modify their rules of behaviour, and whose actions are perfectly coordinated in spite of random shocks that impinge on the system. The agents are thought of as playing a game with nature over and over forever and their optima1 strategies depend on those of nature. It is in this context that Lucas makes a crucial assumption: the mode1 is not merely a characterization of equilibrium that possesses certain well defined properties if and when it is brought about; it is a characterization of the behaviour of agents. It is a statement of the way the economy works. If ‘nature’ changes her strategy, then all the other agents will adopt the optima1 equilibrium set of counter strategies, which together with certain additional assumptions taken up later, give a sophisticated explanation of why government monetary policy may be neutral or even counter productive. Lucas knows, like Frank Knight before him, that this assumption is extreme Address: University of Southern California, US. 177

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and not to be taken literally as descriptions of real people in actual households and firms. Knight, however, took it as axiomatic: ‘the market’ enables the outcome of all transactions to work in equilibrium or to work as if it were in equilibrium. Recent research reported after the appearance of Lucas’ volume by Hildenbrand and subsequently by Grandmont has lent a certain credence to this position by showing how merely feasible behaviour by consumers in a competitive market can lead to aggregate demand patterns consistent with weak forms of consistency, literally as if those aggregates had been determined by a rational consumer. Lucas provides an alternative justification, however, that enables him to omit any discussion of markets at all. It is that agents have ‘rational expectations’, a term originated by John Muth in a famous paper of 1961, and a concept employed by Cassel much earlier in the century to explain how an economy can work according to Walrasian laws if its households and firms expect the equilibrium prices. This means that all the decision makers know the solution to the problem which it is ‘the market’s’ function to solve. In Lucas’ terms rational expectations means that at any one time all agents ‘know’ the stochastic properties of the economy and all the relationships that will govern all transactions forever. It implies the ability to solve (or to act as if they had solved) not just a Bellman functional equation, but a set of Bellman’s equations simultaneously for all agents and all at the same time in a manner that satisfies all the market clearing equations of the economy. The agents do not know what will actually happen because random shocks impinge on the system at all future dates. The optimal strategies, however, reveal their best responses consistent with market clearing once nature has revealed her hand. Without saying it in so many words, by ‘nature’ Lucas means government and this is the basis of his famous Lucas critique: that a change in policy by government changes the law of motion of the economy both in itself and by changing the strategies of the agents on whom it impinges. The upshot of all this is that one would assess current policies by working out the equilibrium of the new game they imply. This is the radical reorientation that Lucas deems necessary. Chapter III uses the theory sketched out above together with a specific functional form for the household utility function in an ingenious estimate of the potential benefits to government stabilization policy. He finds that economic instability at the level experienced since the Second World War is a minor problem. The benefit involves not more than 2% of total consumption expenditure. The primary purpose of improved business cycle theory, he argues, is therefore that of helping us see how to prevent the government from adopting policies that don’t make matters worse. Chapter IV now provides an exegesis of an empirical version of the equilibrium business cycle theory developed by Kydland and Prescott. Here Lucas again emphasizes his commitment to that theory as a description ‘of the way the economy actually works’ (p. 32). Emphasis also is placed on the role that stochastic shocks play in providing the impulses which are propagated in the way described by Frisch in a celebrated early article and which lead to time series data that look very much like macroeconomic time series in the sense that Slutsky had observed about a decade before Frisch, except that here the dynamic equations incorporate specific assumptions about preferences and technology. Business cycles in this theory then are ‘caused’ by shocks. Subsequent work in this genre has included alternative specifications of where shocks enter. Lucas, we recall, originally assumed (1974)) following Friedman, that they were of a momentary nature; Kydland and Prescott that they reflected tastes. random technological shifts; others have argued that they influenced Parkin, in a recent study, attributes them to shifts in the substitution elasticity

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between skilled and unskilled labour. He finds that the Great Depression, instead of being caused by a change in the preference for leisure as some have suggested, was an efficient economic response to a temporary advantage accruing to skilled labour! Thus, there is no involuntary unemployment in the equilibrium business cycle framework. All changes in the employment of labour and capital capacity are seen as voluntary responses to the vicissitudes of the market as it is buffeted about by random shocks. Emphasizing the contrast with Keynesian disequilibrium theory in Chapter V, Lucas again takes an unequivocal stand in favour of the equilibrium approach by extending its methodology to the explicit recognition that employment involves search and job matching. Search out of employment, and therefore unemployment, is an activity which, like any other, can be rationalized in equilibrium terms. Lucas summarizes this approach in characteristically cogent passages and also characteristically with generous acknowledgement to other pioneers in this area, such as J. J. McCall. He then turns to the job of matching part of the story by appealing to the game theoretic treatment of bargaining when information matters. He concludes by drawing harsh comparisons with the Keynesian traditions which did not explain why people are unemployed but only that hours of labour in the aggregate would be. This is a ringing challenge that has not yet found a completely convincing and equally rigorous counter argument. Chapter VI provides an exceptionally clear explanation of how the intertemporal equilibrium in theory implies the standard quantity-theoretic implications for the neutrality (read ineffectiveness) of monetary policy and why it implies that (in equilibrium remember) instrumental changes by monetary authorities may amount to little more than nominal erratic disturbances in the money supply and the price level. Lucas emphasizes at the beginning of this discussion that his approach as currently embodied in empirical work is not yet able to account for the occasional very large fluctuations in GNP and employment. But he expresses the view that a solution to this problem will involve further development within the equilibrium framework and not ‘surrendering to [the] temptation’, as did Keynesians, to resort to ‘some other, different kind of theory’ (p. 108). Chapter VII speculates on extensions of the theory that would explain these discrepancies and in particular would account for the well established correlation between monetary variables and real activity. He suggests a portfolio approach in which policy shifts induce changes in expectations that cause fully rational ‘people [transacting in equilibrium] to consume more leisure so that . . . employment will 7 fall Lucas concludes this summary of his influential views by commenting on newer efforts to explain short run price and wage rigidities that are often held to be disequilibrium phenomena. To handle these within his framework he suggests that information asymmetries among members of a population of agents would lead decision makers to ‘interpret’ shocks of a monetary origin-as signalling changes in technology or preferences and hence trigger the same kind of dynamic response that technology shocks do. By implication this would cause sufficient variation to explain what technological shocks by themselves cannot do. Chapter VIII wraps it all up with a brief summary and re-emphasis of the major points of methodology and their implications for policy. He is emphatic about his belief that the microeconomic theory he exploits is the ‘only engine for the discovery of truth’. This raises his vision to the level of a paradigm, a Weltanschaung, literally a way of seeing and interpreting experience. Text books have appeared that are dominated by this view. Older texts have been rewritten to acknowledge it at least, some even to purge themselves of Keynesian views.

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The book is a masterpiece of scientific writing and methodological persuasion. Assumptions are stated clearly and precisely, implications are drawn rigorously, and opinions distinguished as such. The role of models and of mathematical reasoning is affirmed in compelling terms and the requirement to confront deductions from them with facts stated in convincing fashion. If for no other reason, every economist should read it as a standard of expositional clarity to which they and their students should aspire. Having thus confessed my keen admiration, I turn now to the limitations of this work and the paradigm it offers. I see three that are fundamental. First, is the crucial role attributed to shocks. These are impulses, to technology, to tastes, to policy instruments that drive everything of interest. They explain why agents have to plan with probabilities in mind, and they ultimately explain the cause for variations in individual behaviour and aggregate measures of economic activity. The implication is that the changes of greatest interest-and that cause the are explained in terms that are not and cannot be explained. greatest problemsThus, the Great Depression or the Black Mondays are explained as being caused by shocks to technology, or to preferences or to government error, or to a combination of them. The reader may ask if this is not reintroducing ad hocery in the back door after it has been ceremoniously ushered out the front. Actually, research that was already being published in the 1980s work by Benhabib and Nishamura, Woodford, Montrucchio, Boldrin, and by now a considerable number of others, demonstrated that intertemporal equilibrium growth theory could generate fluctuations of an erratic nature with no shocks at all but entirely through the intrinsic interplay of rational substitution effects working in intertemporal equilibrium. I suggest that most, perhaps all, of Lucas’ inferences could be drawn from models that attribute the uncertainty facing decision-makers as a derivative of the operation of the system itself. Indeed, in a recent working paper Mordecai Kurz has initiated work that could lead in this direction using ideas from ergodic theory that are gradually being introduced into economic theorv. The limitation of ad hoc shockery can be overcome in this way, but two others that are far more serious cannot. One is the use of optimal dynamic programming strategies to represent individual rationality; the second is that the strategies are so intricately coordinated that they are all consistent with one another, i.e. once random shocks occur, equilibrium prices magically emerge and spot market clearing transactions take place. These assumptions are indeed characteristics of They are axioms upon which the formal theory is intertemporal equilibrium. built. However, Lucas’ paradigm sees these axioms as the ‘only engine’ for rigorous economic work. It is here that Lucas-in snite of solemn invocations of Walras and Marshall-parts company with the neotclassical school and marches off on the very peculiar tangent of his own. For neither Walras, nor Marshall, nor Cournot before them, thought that real world economies work in equilibrium. Instead, they saw individuals adjusting step by step, period after period, to the current economic situation, economizing at the margin (Marshall), or choosing a mistakenly optimal allocation on the basis of incorrect expectations (Cournot), or reacting to prices ‘optimally’ that respond iteratively to discrepancies in excess demand (Walras). Moreover, virtuallv all business cvcle theorists before 1974 conceived of cycles as the result of4 disequilibrium ‘forces. Certainly, Hayek (whose immature phrase inspired Lucas’ seminal 1974 paper) came to see decentralized markets as the deux ex machina for the working of economic exchange in an adaptive, evolutionary way. Elsewhere, I have shown why an economy of agents, who find it costly to think, must work in disequilibrium if anv of them spend the time. effort and resources to optimize procedurally, i.e. to actually try to solve optimizing problems. In my

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view markets do not provide Adam Smith’s or Frank Knight’s magic because what they actually are is a network of enterprises peopled by agents of limited cognitive powers who supply producers and consumers with services of mediation that radically lower the cost of economic transactions when the latter wtust occur i.e. when everyone has plenty to learn, when the wrong in disequilibrium, strategies are often employed by both private and government agents, and when creative thinking is constantly introducing new elements-entirely unforeseen ones-to the economic game. Moreover, I claim that these latter perturbations are endogenous in the sense that they arise from the same properties of mind that underlie any kind of rational thought, namely, the ability to imagine things that do not yet exist, to think about acts that have never before been experienced. This direction leads to a different vision, a different paradigm. The difference matters. The equilibrium paradigm is the basis for advice being given now to countries floundering between socialism and capitalism to adopt a ‘quick fix’ of free markets, to jump to them in a ‘big bang’. Fine advice for us to give having inherited 3000 years of development of money, markets, and supporting government infrastructure. 1 In fact, markets and democratic institutions have co-evolved in disequilibrium. Economic changes have often provoked political ones. To be sure, developments of political institutions have sometimes hampered change and distorted economic adjustments, but crucial ones have facilitated the process of economic development and have made private property and all it entails possible. Is it not significant also that the post World War II period, for which Lucas estimates such a low social cost of business fluctuations, is exactly the period in which Keynesian macroeconomic policy held sway and instruments of monetary and industrial regulations were fully active? Do we not now observe an increasing vulnerability of banks and rapidly widening gaps between haves and have nots in the last decade when the mechanisms of regulation have been successively dismantled under the banner of the ‘free market’ paradigm? In my opinion no greater mischief can be done by economic theorists that to train people to think of government as a random shock. What is needed is to identify the precise, complementary rules that government agencies can, must or should play to facilitate decentralized decision making and exchange among individuals and organizations who function out of equilibrium because by the nature of the system they must. Lucas has given a brilliant exposition of a different paradigm, one based on the premise that general equilibrium theory, augmented to include risk and contingent contracts, and defined over an infinite horizon, is the correct-indeed, the approach to a satisfactory resolution of the central only possible -rigorous problems of macroeconomics, those of explaining the character of macroeconomic data and those of providing a scientifically sound basis for formulating and evaluating public policy. The form is a model of scientific prose style, but its substance is severely circumscribed. Of course, theory by nature must be. From a mathematical point of view assumptions are only axioms. Logical implications are incontrovertible-as such. From the scientific point of view, however, assumptions are something else. They are also hypotheses and, as such, must also be confronted with the facts. If we know that theory fails to capture salient features of the way economies work and if these salient features are sure to have an important bearing on how we interpret experience, then we must go beyond them. We must revise the axioms so that-as hypothesesthey do capture the salient features, and we must get on with the task of explaining the implications of those new, perhaps more challenging axiom systems. I would hope that Lucas and other able researchers in the intertemporal equilibrium school, having pushed their paradigm to its logical conclusions, would

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now find employment in the work begun (in very different ways) by Schumpeter and Keynes, but much of which remains to be done; questions to be addressed include that of understanding how an economy of such complexity that no individual understands it can moderate fluctuations without destroying itself; that of determining what private and/or public mechanisms must be invented and implemented to solve socioeconomic problems as they emerge, and what should be done about those individuals or social groups who fail to cope with the changes this vast machine so rapidly brings about.