The Lucas Mystique

There is this thing in economics called the Lucas Critique. You see it pop up every so often and hear it referred to in revered tones. It is, apparently, very important and very, very, insightful. It has a lot to do with the state of economics today. Which, as you know, I think of as being lamentable.

What is this Critique?

Well, in a nutshell, it says that there are special features of an economy that are “deep”, by which it means they don’t move about in the face of policy changes. Other features, presumably the “shallow” ones do. This is important because it implies that policy makers have to be sure that the things they are trying to influence don’t slip and slide about too much in reaction to their policies and, in effect, neutralize those policies. In short: Lucas says people take policy into account, make suitable adjustments, and thus render some – if not all – policies ineffective.

Not quite. The only policies that are ineffective are those that are based on those “shallow” features. Which, it turns out, happens to be pretty much anything Keynesian.

Why?

Because Keynes focused on macro effects and dealt with large scale or aggregate features of the economy. Things like aggregate demand for instance. He didn’t spend much time mucking around with the behaviors of individual people of businesses. Or, at least, he felt comfortable dealing with aggregates and presumed they had analytical validity. Lucas argued that such aggregates are not “deep” because they do not take into account the possible adjustments made by people and firms when confronted by policy changes.

To get around this problem Lucas and his followers urged economists to rebuild their models of the economy – the ones used for policy advice – on the more substantial “deep” features that offered a more concrete basis for analysis. Since these were presumed to be those features theorized about within what is called microeconomics, new models of the economy, and therefore macroeconomics, had to henceforth be built on what is nowadays called a “micro-foundation”.

How nice.

Or at least it would be were those micro foundations worth a lick. Which they aren’t. They are absurd. What the Lucas Critique effectively reduced economics to was a combination of applied math  built on top of the results of what is a kind of psychology. Bad psychology. Other worldly psychology. Economists who operate within the confines set by the Lucas Critique build huge model superstructures on the decidedly sandy foundations of nutty and wholly unrealistic views of how people act.

Since real people tend to be a little idiosyncratic, odd, and sometimes unreliable, and since it is difficult to model such traits, economists swept them under the carpet and hypothesized something altogether different. That something being easier to fit into mathematical models and thus manipulate.

Since economists find it easier to model rational behavior, people became rational in the models. And not just rational in the manner of being sensible, but hyper rational in the manner of being an automaton.

Since people sometimes differ even when they’re being rational, economists decided to use only one – a “representative” – in their models. They did the same for businesses. Not only this, they decided that all the goods and services in the economy – hair cuts and motor cars – are substitutes for each other. This helps get around the knotty problem of what people do when they make decisions on what to spend they money on. Not that economists allow them to change their minds in the models. And not that money is ever really built in either. Getting rid of money was quite a coup because it meant economists didn’t have to worry about why people might not spend everything they earned. Instead economists could simply focus on a moneyless economy and study “real” things like widgets and corn bushels. You know, the stuff we all buy.

These micro-founded models are the ones that failed to predict the crash. No wonder. They are “deep”. So deep they are lost in the mud at the bottom of a very deep and opaque analytical imaginary world where the light of the real world never penetrates.

Nonetheless the Critique stands proudly as a totem of great insight.

It provides cover for those who want to deny the real world. Those who deny that the whole is greater than the sum of its parts. Those who deny that properties emerge at various levels of aggregation and are not thus based on anything below them. Those who prefer to deny that humans are diverse and complicated. Those who prefer to limit themselves the very special circumstances of the highly unlikely possibility of an equilibrium. Those who are desperate to laud market magic as the panacea to all that ails an economy. And those who, for some unimaginable reason, seem to think that modern economics has something useful to say about a society’s ability to accrue and distribute wealth.

The Critique is not a critique. It is a mystery. A Mystique. Another of a line of great sounding insights that melt into commonsensical vapor when probed. Of course we ought to take people into account when we model an economy. Of course their reactions to policy matter. Duh. Only an economist would think this is an insight worthy of having a special name.

Lucas gave his critique in the context of his program to introduce rational expectations into economics., but his critique does not depend on rationality. It depends simply on the observation that people have expectations and adjust them when the suite of facts they face changes. Wow. People change their minds periodically. Who knew?

Economics has endured an epic decades long journey into irrelevance partially instigated by the Lucas Critique, and the paraphernalia of the micro-foundations it elevated to canonical status. Meanwhile Keynesian analysis has reemerged as the relevant focal point for policies that actually solve problems.

Lucas lost. Critique and all.

Now, if only we could get people to understand that “market clearing” and “equilibrium” are not the same thing. But that’s another topic.