Liveblogging World War II: September 26, 1941
Rui Pedro Esteves: International Finance in the Belle Epoque: French Portfolio Exports, 1880-1913

The Idea That Recessions Arise When Workers Do Not Understand How Many Commodities Their Paychecks Would Be Was Not One of the Brightest Lights on Humanity's Tree of Good Ideas

But the idea that recessions arise when workers do not understand how many commodities their paychecks will buy was (one of) Robert Lucas's big ideas.

Paul Krugman picks up the story:

Lucas In Context: In the 1970s, Lucas and disciples take it up a notch, arguing that we should assume rational expectations: people make the best predictions possible given the available information. But in that case, how can we explain the observed stickiness of wages and prices? Lucas argued for a “signal processing” approach, in which individuals can’t immediately distinguish between changes in their wage or price relative to others — changes to which they should respond by altering supply — and overall changes in the price level.

In the 1980s, the Lucas project failed — pure and simple. It became obvious that recessions last too long, and there are too many sources of information, for rational confusion to explain business cycles. Nice try, with a lot of clever modeling, but it just didn’t work.

One response to the failure of the Lucas project was the rise of New Keynesian economics…. The difference from old Keynesian economics was the effort to use as much maximizing logic as possible to interpret spending decisions. I find NK economics useful, if only as a way to check my logic, although it’s not really clear if it’s any better than old-fashioned Keynesianism.

The other response, by those who had already invested vast effort and their careers in the Lucas project, was to drop the whole original purpose of the project, which was to explain why demand shocks matter. They turned instead to real business cycle models, which asserted that the ups and downs of the economy are caused by technological shocks magnified by rational labor supply responses…. [T]he math was impressive, and RBC became a self-contained, self-replicating intellectual world.

The Lesser Depression arrives. It’s clearly not a technological shock; clearly, also, nobody is confused about whether we’re in a slump, as the old Lucas model required.

In fact, it looks a lot like what Keynes described, and old-Keynesian models work very well, thank you, both at explaining it and in making predictions about such things as interest rates and the effects of fiscal austerity. But the descendants of the Lucas project know that Keynes was wrong — it’s what their teachers and their teachers’ teachers have been saying all these years. They cannot accept anything resembling a Keynesian explanation without devaluing everything they’ve done with their intellectual lives.

So it must be Obama’s fault!