Those of us who spent our youth studying economics came away stunned by the originality of thought demonstrated by Robert Lucas, the Nobel Prize winning economist from the University of Chicago. Especially for those of who lived through pre-liberalisation India and saw the damage that socialism and Keynesian thinking could unleash on an under-developed country, Lucas’ work – and the challenge it posed to the Keynesian orthodoxy – was like manna from heaven. As the FT explains in his obituary:

“…Lucas had already published one of the papers for which he is best known — applying the hypothesis of “rational expectations” — in which he took on the prevailing view that governments could cut unemployment by pursuing expansionary policies that would also lead to higher inflation.
Lucas formulated a model showing that such attempts would fail because people adjust their behaviour once they have learned to expect higher inflation. The idea, as his former colleague John Cochrane puts it, was that “you can [only] fool people once or twice”.

A later paper, in 1976, introduced what is now known as the “Lucas critique”, arguing that macroeconomic models would fail if they relied on past behaviour. Economists would not be able to predict the results of changes to exchange rate, monetary or tax policies unless they took account of how behaviour might change as a result.”

Indian readers of Lucas’ work could instantly identity with Lucas’ critique of Keynesianism. In specific, as we have seen over the past several decades in India, it does not matter for job creation in India, how much or how little the Government spends. Over long periods of time, Government spending does not create jobs in India or anywhere else. On the other hand, excessive Government spending does stoke inflation which in turn drives up the cost of capital (or cost of borrowing). That in turn crimps the level of economic activity. All of this sounds like common sense today. It wasn’t when Lucas wrote about it more than 50 years ago. RIP Robert Lucas.

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