Sidestepping the Lucas Critique

One of the big watershed moments of the past few decades of macroeconomics is the Lucas Critique. Noah Smith explains:

The Lucas Critique is simple, and it is correct. If you have a model of the economy that works pretty well, and you try to use that model to predict the effects of a new policy, the policy may change people’s behavior so that your model no longer works pretty well, thus leading (among other things) to the policy failing to have its intended effect.

The Lucas Critique was applied by Lucas to invalidate many of the “Phillips Curve” models of the 1970s. The idea was that if central banks cause inflation in an attempt to pump up growth, people will start expecting higher inflation in general, and the inflation-growth relationship that held in the past would change. That seems to have been borne out by the events of the 70s. And so people started to think that the Lucas Critique was of great practical importance.

It is of course true that any policy can be anticipated by economic actors, and that should be always kept in mind by economists and policymakers. But, as Noah’s post (which is one of my all-time favorites, you should read it) explains, the critique was taken much further than that—asserting that the only good kind of economic model was one which was “policy invariant,” meaning that it relied on the “deep structures” in the economy which aren’t subject to the whims of government policy.

Of course, economic modelers don’t have any clearly justifiable method for determining whether or not a model satisfies the Lucas Critique:

Instead of looking at evidence, what they do is make a judgment call. If all the pieces of a model sort of intuitively seem like things that wouldn’t change under different policy regimes, then people nod their heads and say “OK, that seems like it satisfies the Lucas Critique”, and they think no more of it. This basically happened with RBC models. “Technology shocks” sound like something that people don’t control, and that therefore couldn’t change if policy changed. And people assumed that the other features of the model (costless price changes, for example) would hold up under different policy regimes as well. So RBC was thought to have satisfied the Lucas Critique.

But more fundamentally, it looks to me that models which completely satisfy the Lucas Critique are impossible. That is to say: there is no such thing as economic factors which are independent of government policy. This seems most true when it comes to something like central bank policy, which necessarily means intervention. Opportunistic disinflation, NGDP targeting, or even the gold standard, all are government choices of one sort or another.

And furthermore, since the Lucas Critique was cooked up by a bunch of right-wingers, it’s always used to argue the point that the government policy won’t have its intended effect (like when the government tries to use inflation to juice employment, firms and individuals may start taking inflation expectations into account, thereby defeating the policy). However there are other cases where the anticipation effect of the policy can reinforce, not defeat, a policy goal.

Yglesias explained how this might work:

In a country of 300 million people, even though many households are burdened by debts, many others are flush. Some firms also have large stockpiles of cash or cash-like low-yield assets. If those with cash or other cash-like assets become convinced that the purchasing power of cash will fall in the near future, then they become more likely to seek opportunities to trade cash for goods or services. If the economy is already near full employment, this increased disposition to buy things will only further push up the price level and you’ll risk an inflationary spiral. But if the economy features many idle resources — unemployed workers, vacant storefronts, idle factories, etc. — then the increased disposition to buy things will mostly express itself in the form of increased real output. Some items that are objectively scarce (gasoline, e.g.) will also see price increases, but by and large if people wanted to buy more stuff, we have the ability to make it. And if people thought that the purchasing power of their money was likely to decline in the near future, they would try to trade money for stuff.

So Lucas Critique, then, is just the conservative’s half of the expectations coin. The question for policymakers, especially the Federal Reserve, is whether the anticipatory effects of a new action are likely to undermine the policy or reinforce it, and by how much. Trying to find a policy-invariant model is a mug’s game.

@ryanlcooper

Ryan Cooper

Ryan Cooper, a contributing editor of the Washington Monthly, is currently the Washington correspondent for The Week.