Lucas On the Unimportance of Business Cycles

Robert E. Lucas Jr. won his Nobel Prize in 1995 for work he’d done in the the 1970’s on business cycles.

By the late 1980’s his tune had changed subtly. He didn’t think that his earlier work was unimportant (no one does) but that it allowed him to quantify how important business cycles were to the average Joe, and the answer is “not very”.

He made this point most forcefully in a 1988 book entitled Models of Business Cycles.

Models are the key for how we think about the world. Lucas’ big contribution in macroeconomics was in developing models that were more difficult to find faulty with:

… Participants in the discussion [about policy and business cycles] must have, explicitly or implicitly, some way of making a quantitative connection between policies and their consequences. [pg. 6]

This points to a big problem in our current situation. No one seems to be able to figure out what model the Bush people had in mind when thinking about the recession, and while everyone agrees that Obama won because voters believed he could bring change, with respect to macroeconomics this seems to be a change back to a discredited model of the economy.

Lucas’ particular sort of model is capable of showing two things about growth and business cycles that no one was able to quantify before.

• The welfare gains from small changes in growth rates are huge: that Americans would be willing to give up something like half of their current level of income in exchange for the growth rates they have in China. This is broadly in line with what the Chinese actually have forsaken to get those growth rates – although Lucas wrote this before there was any awareness that China was undergoing a growth miracle. [pp.20-25]
• The welfare gains from reducing the variability of our growth rates to zero (i.e., eliminating business cycles) are almost non-existent: we appear willing to give up between 0.1% and 1% of our average annual growth rate to live in a perfectly stable world. [pp. 25-31]

Note the elephant in the room of the first point: many people around the world have given up that amount of current income to not get growth anywhere near what the Chinese are getting. Something must be really goofed up with their economies.

And, putting some numbers on the second one might help a bit. Our business cycles have growth rates that are broadly like 3% plus or minus 5% each year. Lucas is saying that to get the second number down to zero, we’d only be willing to go down to between 2.0 and 2.9%. That isn’t much.

All of this is a hugely strong argument for spending a lot more time looking at growth rather than business cycles, and it is one that the profession of economics has not been able to seriously weaken in 20 years of trying.