Robert Lucas and the Lucas Critique

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The Society for Economic Dynamics has a short and delightful interview with Robert Lucas in the November 2012 issue of its newsletter, Economic Dynamics. Lucas, of course, received the Nobel prize in economics in 1995 and is, among other distinctions, the originator of the eponymous "Lucas critique," which the Nobel committee described in this way:

 "The 'Lucas critique' - Lucas's contribution to macroeconometricevaluation of economic policy - has received enormous attentionand been completely incorporated in current thought. Briefly, the'critique' implies that estimated parameters which werepreviously regarded as 'structural' in econometric analysis ofeconomic policy actually depend on the economic policy pursuedduring the estimation period (for instance, the slope of thePhillips curve may depend on the variance of non-observeddisturbances in money demand and money supply). Hence, theparameters may change with shifts in the policy regime. This isnot only an academic point, but also important foreconomic-policy recommendations. The effects of policy regimeshifts are often completely different if the agents' expectationsadjust to the new regime than if they do not. Nowadays, it goeswithout saying that the effects of changing expectations shouldbe taken into account when the consequences of a new policy areassessed - for instance, a new exchange rate system, a newmonetary policy, a tax reform, or new rules for unemploymentbenefits.

"When Lucas's seminal article (1976) waspublished, practically all existing macroeconometric models hadbehavioral functions that were in so-called reduced form; thatis, the parameters in those functions might implicitly depend onthe policy regime. If so, it is obviously problematic to use thesame parameter values to evaluate other policy regimes.Nevertheless, the models were often used precisely in that way:Parameters estimated under a particular policy regime were usedin simulations with other policy rules, for the purpose ofpredicting the effect on crucial macroeconomic variables. Withregime-dependent parameters, the predictions could turn out to beerroneous and misleading."

Perhaps it's useful to add a specific example here. Say that we are trying to figure out how much the Federal Reserve can boost the economy during a recession by cutting interest rates. We try to calculate a "parameter," that is, an estimate of  how much cutting the interest rate will boost lending and the economy. But what if it becomes widely expected that if the economy slows, the Federal Reserve will cut interest rates? Then it could be, for example, that when the economy shows signs of slowing, everyone begins to expect lower interest rates, and slows down their borrowing immediately because they are waiting for the lower interest rates to arrive--thus bringing on the threatened recession. Or it may be that because borrowers are expecting the lower interest rates, they have already taken those lower rates into account in their planning, and thus don't need to make any change in plans when those lower interest rates arrive. The key insight is that the effects of policy depend on whether that policy is expected or unexpected--and in general how the policy interacts with expectations. The parameters for effects of policy estimated under one set of expectations may well not apply in a setting where expectations differ.

As the Nobel committee noted more than a decade ago, this general point has now been thoroughly absorbed into economics. Thus, I was intrigued to see Lucas note that the phase "Lucas critique" has become detached from its original context in a way that can make it less useful as a method of argument. Here's Lucas in the recent interview:

"My paper, "Econometric Policy Evaluation: A Critique" was written in theearly 70s. Its main content was a criticism of specific econometricmodels---models that I had grown up with and had used in my own work. Thesemodels implied an operational way of extrapolating into the future to seewhat the "long run" would look like. ... Of course every economist, then as now, knows that expectations matterbut in those days it wasn't clear how to embody this knowledge inoperational models. ... But the term "Lucas critique" has survived, long after that originalcontext has disappeared. It has a life of its own and means different thingsto different people. Sometimes it is used like a cross you are supposed touse to hold off vampires: Just waving it it an opponent defeats him. Toomuch of this, no matter what side you are on, becomes just name calling."

Lucas offers some lively observations on dynamic stochastic general equilibrium models, differences across business cycles, and microfoundations in macroeoconomic analysis. But his closing comment in particular gave me a smile. In answer to a question about the economy being in an "unusual state," Lucas answers:  "`Unusual state'? Is that what we call it when our favorite models don'tdeliver what we had hoped? I would call that our usual state."