What is the Lucas Critique?
The Lucas Critique refers to Robert Lucas' 1976 paper where he argues that one should not base an economic policy entirely on a pattern observed in historical data because agents will adapt to the policy and the pattern may cease to exist. He summaries it as:
"Given that the structure of an econometric model consists of optimal decision rules of economic agents, and that optimal decision rules vary systematically with changes in the structure of series relevant to the decision maker, it follows that any change in policy will systematically alter the structure of econometric models.”
Lucas, Robert (1976). "Econometric Policy Evaluation:
A Critique”
As the story goes, Old-Keynesians thought that the Phillips relationship between inflation and unemployment was a constant rule as such they could base policy upon it. However this lead to the inflation of the 1970s as the policies themselves caused the relationship to break down. Then the Lucas critique was able to convince the profession that it need to move on from Old-Keynesianism and start micro-founding all mainstream models. Now whether you think this is what happened or not (it wasn’t exactly) it is not crucial to the substance of this post.
Now Lucas wasn't the first person to highlight this phenomenon but often in economics (as in life) it is not about saying the right things, it is about the right person, saying the right things, at the right time. The Lucas Critique, is generalised into what is known as performativity.
How do you “pass” the Lucas Critique?
Whenever someone presents a model not part of the micro-founded, DSGE, mainstream set of models, the usual disregarding trope is “this wouldn't pass the Lucas Critique”. So what on earth does it mean to pass the Lucas Critique? Well first presumption would be that it passes if a policy is enacted based on this model, it wouldn't change the statistical patterns. But what ex-ante way do we have of deciding whether a model passes? The usual argument is whether or not the model has micro-foundations.
But do introducing micro-foundations mean that you avoid the Lucas-Critique, what are these preferences, these “deep parameters” so inherent to the human condition that they transcend the social environment? Preferences don't exist in an atomistic manner. Micro-foundations do not avoid the Lucas critique.
When you think about fashions and fads, this is of course
obvious. Even with micro-foundations one cannot avoid the implications
of performativity.
If you're right and we can't avoid the performativity,
what does the whole of the economic profession do?
I by no means want to throw the baby
out with the bath water, economics models are not useless. What I wish to
happen is the economic profession to expand the tools which they use. As none
of the tools which are useful “pass” the Lucas Critique, the Lucas Critique
should be redefined as a scale. With this scale if a pattern is found and a
subsequent policy recommended by a model, then a Lucas scale sensitivity
analysis should occur and observe whether the same result is elicited. Indeed,
if the same result is not elicited it would be more interesting to discuss why
it has not been in this case, than the result itself.
Economists are not unfamiliar with sensitivity analysis,
indeed is an important part. This is just another aspect of sensitivity
analysis which should occur before a policy recommendation.
After completing a micro-founded DSGE model, an economist
could do an econometric study to see if the estimates of the effect are
similar. Then perform an agent based model to see whether in this case the meso
casual mechanisms involved do affect the aggregation.
This post is not in itself a criticism of micro-foundations or in fact DSGE models, instead it tries to encourage pluralism of different methodological tools in economics. Additionally, end the instant disregarding on anything that is not DSGE on the basis it does not pass the Lucas Critique, because in the social world nothing does.
This post is not in itself a criticism of micro-foundations or in fact DSGE models, instead it tries to encourage pluralism of different methodological tools in economics. Additionally, end the instant disregarding on anything that is not DSGE on the basis it does not pass the Lucas Critique, because in the social world nothing does.
Other interesting posts on this issue:
Understanding Society - Issues on micrfoundations: http://understandingsociety.blogspot.co.uk/2013/10/issues-about-microfoundations.html
Facts and Other Stubborn Things - I think it was the Lucas Critique, not stagfltion
http://factsandotherstubbornthings.blogspot.co.uk/2012/12/i-think-it-was-lucas-critique-not.html
Dan Davies - “Microfoundations” ain’t so microfounded https://medium.com/bull-market/microfoundations-aint-so-microfounded-315b46775432
Facts and Other Stubborn Things - I think it was the Lucas Critique, not stagfltion
http://factsandotherstubbornthings.blogspot.co.uk/2012/12/i-think-it-was-lucas-critique-not.html
