Fine-Tuning or No Tuning?

Article excerpt

Here is a theory that once enjoyed the status of economic holy writ: When an economy goes sour, businesses cut prices and workers accept lower wages. As costs and prices fall, demand rises to meet supply and the sluggish economy automatically perks up at a new "equilibrium."

In other words, depressed economies contain a built-in self-cure.

Students of economics will recognize here the dim outlines of the "classical" market theory that prevailed well into the Great Depression, when real-world conditions belied it spectacularly. And indeed, it was not until John Maynard Keynes published his "General Theory of Employment, Interest and Money" in 1936 that economists began to see why depressions were not necessarily self-correcting.

Keynes' recommendations were so shocking to the old order that their merit was very slowly conceded. Governments, he said, should if necessary borrow to stimulate demand; and it would be better to hire people to dig holes or build pyramids (policies still dismissed by smart-aleck ignoramuses as "leaf-raking") than to wait for grotesque levels of unemployment to correct themselves.

What is my point? A tutorial in Economic Theory 101? No, a random thought or two inspired by the news that Robert Lucas Jr. of the University of Chicago has won the Nobel Memorial Prize in Economic Science. My learned friends tell me that it is richly deserved.

About a quarter-century ago, Lucas devised "rational expectations" theory, which says in essence that major actors in the economy become so canny through experience that they know all the government's moves and anticipate and discount their results - ultimately nullifying their intended effect.

No doubt there is truth here, as there is in Lucas' skepticism of the wisdom of his own guild. "As an advice-giving profession," he once declared, "we are way over our heads."

It is now said that Lucas and his disciples have dealt a death blow to the "myth" of "fine-tuning," the idea that government fiscal and monetary policies can chart the course of a sophisticated mixed economy like that of the United States and the other major industrial powers.

Let us concede, as many economists now seem to do, that "rational expectations" will trump "fine-tuning" in most instances. …