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 macroeconometric evaluation of economic policy – has received enormous attention and been completely incorporated in current thought. Briefly, the \’critique\’ implies that estimated parameters which were previously regarded as \’structural\’ in econometric analysis of economic policy actually depend on the economic policy pursued during the estimation period (for instance, the slope of the Phillips curve may depend on the variance of non-observed disturbances in money demand and money supply). Hence, the parameters may change with shifts in the policy regime. This is not only an academic point, but also important for economic-policy recommendations. The effects of policy regime shifts are often completely different if the agents\’ expectations adjust to the new regime than if they do not. Nowadays, it goes without saying that the effects of changing expectations should be taken into account when the consequences of a new policy are assessed – for instance, a new exchange rate system, a new monetary policy, a tax reform, or new rules for unemployment benefits.
\”When Lucas\’s seminal article (1976) was published, practically all existing macroeconometric models had behavioral functions that were in so-called reduced form; that is, the parameters in those functions might implicitly depend on the policy regime. If so, it is obviously problematic to use the same 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 used in simulations with other policy rules, for the purpose of predicting the effect on crucial macroeconomic variables. With regime-dependent parameters, the predictions could turn out to be erroneous 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 the early 70s. Its main content was a criticism of specific econometric models—models that I had grown up with and had used in my own work. These models implied an operational way of extrapolating into the future to see what the \”long run\” would look like. … Of course every economist, then as now, knows that expectations matter but in those days it wasn\’t clear how to embody this knowledge in operational models. … But the term \”Lucas critique\” has survived, long after that original context has disappeared. It has a life of its own and means different things to different people. Sometimes it is used like a cross you are supposed to use to hold off vampires: Just waving it it an opponent defeats him. Too much 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\’t deliver what we had hoped? I would call that our usual state.\”