Weak defenses of the Lucas/Prescott Program

In the 1970s, Robert Lucas perceived that there was a big problem in macroeconomics. Models that didn't allow for human beings to adjust their behavior couldn't be used for policy, because if you tried to use them, people would alter their behavior until the models no longer worked. This is known as the "Lucas Critique". The solution, Lucas said, was to explicitly model the behavior of human beings, and to only use macro models that took this behavior into account. This is called the "microfoundations" approach. Readers of this blog will know that I am a fan of the general idea.

But in economics, as in many sciences, simply tearing down existing theories doesn't satisfy people. You have to replace the old with the new, or people will just go on using the old. The first research program that came along and tried to answer the Lucas Critique was the "Real Business Cycle" program. This program, spearheaded by researchers such as Ed Prescott, made use of a new modeling approach called "DSGE". It also incorporated Robert Lucas' "Rational Expectations Hypothesis". Lucas didn't invent all of this stuff, but since A) it was invented in response to his Critique, B) he invented some of it, and C) he seemed to sign off on the parts he didn't invent, I feel justified in calling this new research program the "Lucas/Prescott Program" (as in the title of this post).

Anyway, as I've mentioned before, DSGE took over the macro field, and Rational Expectations became nearly as common. Now, in the aftermath of the crisis, both of these are coming under increasing skepticism, from some economists, but especially from the general public. In a recent blog post, Justin Fox expresses this skepticism and mentions some defenses of the Lucas Program (including one by Lucas):

Nobelist Robert Lucas says we're never going to have "a set of models that forecasts sudden falls in the value of financial assets." There's a certain logic to that. Lucas again: "If an economist had a formula that could reliably forecast crises a week in advance, say, then that formula would become part of generally available information and prices would fall a week earlier." But I don't think it's logically impossible to be able to judge when asset markets are at greater risk of trouble than normal. And I wouldn't be too certain that the various classes of macroeconomic models (DSGE models among them) that have evolved from Lucas's rational expectations work in the 1970s are the best possible tools for making such judgments. You could describe what today's macroeconomists are doing as the forward march of science: they're revising and adding to their theories in light of new evidence. But sometimes scientists hit dead ends. Ever heard of phlogiston? 

I'm not saying the DSGE theorists should give up — their work may turn out to be of great value. I'm just saying that policy makers and others who want to understand the short-term movements of the economy should keep their options open. And those who educate macroeconomists should be more open to different methods as well...My view of the Great Recession was very much shaped by an October 2008 phone call with Eichengreen: "I doubt that we'll be able to avoid double-digit unemployment," he told me. "But I'm still confident we can avoid 24% unemployment like in 1933." The U.S. unemployment rate hit 10% for one month in 2009, but didn't go past it. It was a very good forecast, expressed at just about the right level of precision, based mostly on historical experience and off-the-cuff judgment, without a DSGE model in sight. There's more than one valid way to do macroeconomics.

The first issue here is something I've addressed before, so I'll be brief. First off, a "financial crisis" is not necessarily the same thing as a fall in asset prices. If you knew 6 months ahead of time that the financial system was going to break down on some specific day, it's probably true that asset prices would fall as soon as the knowledge was obtained. But it would still be better to have that model, in order to prepare for the consequences of the financial system's collapse.

Second of all, models can make policy-contingent predictions without violating the weak form of the Efficient Markets Hypothesis. If you tell a policymaker, "The financial system will crash 6 months from now, UNLESS you take such-and-such an action," only the policymaker knows what he or she will do. It's private, not public, information. Again, it's better to have the model.

Third of all, market efficiency may not hold. See Abreu & Brunnermeier (2003) for an example of a market in which everyone knows that a crash is coming before the crash comes, but can't make money off of that knowledge. Lucas doesn't know that this kind of thing is impossible; hence, he is making unsupported assertions.

Now onto the second critique. Fox's story about Barry Eichengreen's successful predictions regarding the recent recession is just one data point, it's true. Eichengreen might have just gotten lucky. But the larger issue is that DSGE models have so far proven themselves to be essentially useless at forecasting the macroeconomy, relative to the judgment-based forecasts of people like Eichengreen.

Now, there are two reasons why we might value a macroeconomic model. One is forecasting ability. The other is policy advice. If existing DSGE models are crappy at the former, might they not be useful for the latter? In fact, they might be, and their supporters insist that they are. But with little consensus in the macro profession on how to choose which model applies to the economy at which time, we find ourselves at any given time with a dizzying array of contradictory models instead of one model that we can trust. 

Hence, Fox is exactly right when he says that DSGE models "may turn out to be of great value." As far as we can tell, this has not yet happened. The Lucas/Prescott Program has not yet panned out as hoped, nor are there good logical reasons why other programs couldn't possibly do better. Sometimes scientists are forced to live through long periods of doubt, where old certitudes have crumbled but new ones have not yet arrived to take their place. We appear to be living through such a time.


Note: Let no one interpret this post as an attack on Lucas as an economist. I like Lucas! The Lucas Critique was spot-on. I agree with Lucas' push for microfoundations. And I think the Lucas Islands Model is neato.