Thursday, March 10, 2011

The Lucas Critique

From the Wikipedia:

The Lucas critique, named for Robert Lucas′ work on macroeconomic policymaking, argues that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data.

The basic idea pre-dates Lucas' contribution (related ideas are expressed as Campbell's Law and Goodhart's Law), but in a 1976 paper Lucas drove home the point that this simple notion invalidated policy advice based on conclusions drawn from large-scale macroeconometric models.

The Lucas critique suggests that if we want to predict the effect of a policy experiment, we should model the "deep parameters" (relating to preferences, technology and resource constraints) that govern individual behavior. We can then predict what individuals will do, taking into account the change in policy, and then aggregate the individual decisions to calculate the macroeconomic effects of the policy change.

To reiterate, policy must be concerned with technology, resource constraints, and the preferences that govern individual behavior. This leaves me feeling all empty inside. Where is the focus on money? On debt? On maintaining balance between the two?
Money is the object of every economic act and every economic thought.
If there is no focus on money and debt and monetary balance, it is easy to understand how we ended up with a financial crisis. And it is easy to understand why everybody worries about government debt and why we miss the problem of private-sector debt, even today, even after the financial crisis that caught everybody by surprise.

If there is no focus on monetary balance we can see why economists and policymakers have difficulty understanding how debt accumulation creates problems. And we can see why they want us to use more credit, even now, and why the economy has had to take upon itself the task of deleverage with no help at all from policy.

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