[T]he term "Lucas critique" has survived, long after [the] 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.
This is basically what I was conjecturing in this blog post. Of course Lucas gets to say it more matter-of-factly, because...well, his name is on the Critique. Anyway, here's Lucas on DSGE modeling:
Virtually all macroeconomic models today are dynamic, stochastic and general equilibrium (where here "general equilibrium" means you have the same number of equations and unknowns)...If we narrow the definition of DSGE by using "general equilibrium" to refer to competitive or Nash equilibria where the strategy sets of each agent are made explicit in an internally consistent way then we have Kydland-Prescott and other RBC descendants and not much else.
This is interesting, for several reasons. One is that Lucas expands the definition of "general equilibrium" to include Nash equilibria, which is not the way I've ever seen it done; I have always understood the term "general equilibrium" to be synonymous with "Walrasian equilibrium".
Also, it's interesting that Lucas says that RBC models are essentially the only equilibrium models (of the business cycle, presumably) in which "the strategy sets of each agent are made explicit in an internally consistent way". Is this true? I don't think it is true. For example, take a Calvo model. In a Calvo, model, agents' ability to set prices is restricted by a mysterious, exogenous "Calvo Fairy"...but, given the existence of such a "Fairy", the strategy sets of agents in the model are quite explicit and quite internally consistent. In a Prescott-type RBC model, agents' decisions are constrained by exogenous "technology"; you might think that this is more plausible of an assumption than a "Calvo Fairy", but in terms of its effect on the internal consistency of the strategy sets of the agents in the model, it seems no different.
Or maybe I'm reading Lucas wrong here?
Lucas on the causes of business cycles:
I was [initially] convinced by Friedman and Schwartz that the 1929-33 down turn was induced by monetary factors...I concluded that a good starting point for theory would be the working hypothesis that all depressions are mainly monetary in origin. Ed Prescott was skeptical about this strategy from the beginning...
I now believe that the evidence on post-war recessions (up to but not including the one we are now in) overwhelmingly supports the dominant importance of real shocks. But I remain convinced of the importance of financial shocks in the 1930s and the years after 2008. Of course, this means I have to renounce the view that business cycles are all alike!
In 1980, Lucas had written:
If the Depression continues, in some respects, to defy explanation by existing economic analysis (as I believe it does), perhaps it is gradually succumbing under the Law of Large Numbers.
But with the post-2008 recession looking so similar to the Depression, it seems to have become clear to Lucas that the Law of Large Numbers will no longer do the trick. There must in fact be two types of recessions, with one (more frequent, less severe) type caused by "real shocks", and the other (rarer, more severe) type caused by "financial shocks".
That Lucas has now twice changed his ideas about the underlying causes of the business cycle - the most important question in all of business cycle theory - is in my opinion a reason to admire him. When the facts change, Lucas changes his mind, as any scientist should.
Incidentally, the idea that "financial shock" recessions are different would tend to put Lucas more on the Reinhart-Rogoff side of things. Though Lucas doesn't mention here whether he thinks financial-shock recessions should last longer.
But the fact that history can cause even the smartest of macroeconomists to change his mind about the fundamental question of his field not once, but twice over the course of his lifetime is a stark illustration of the poverty of data that business-cycle theorists have to work with. In a sense, all we can do is watch history go by and hope it repeats itself enough for us to get a handle on what's happening.
Finally, Lucas on microfoundations:
The "[micro]foundations" of...models don't guarantee empirical success or policy usefulness.
What is important...is that if a model is formulated so that its parameters are economically-interpretable they will have implications for many different data sets. An aggregate theory of consumption and income movements over time should be consistent with cross-section and panel evidence...An estimate of risk aversion should fit the wide variety of situations involving uncertainty that we can observe...Estimates of labor supply should be consistent aggregate employment movements over time as well as cross-section, panel, and lifecycle evidence...This kind of cross-validation (or invalidation!) is only possible with models that have clear underlying economics: micro-foundations, if you like.
This is bread-and-butter stuff in the hard sciences.
This I completely and utterly agree with. The power of microfoundations is that they allow unification. They give you the hope of explaining many phenomena in terms of one underlying phenomenon. In fact, there really should be no conceptual difference between the terms "microfoundations" and "unification". Microfounded models - when they work -are inherently more useful and powerful than equivalent "ad-hoc" models.
Of course, as Lucas points out, this makes microfounded models inherently more vulnerable to falsification than other models. An "ad-hoc" non-microfounded model only has to explain one thing, but a microfounded model has to explain many things. This means that as soon as the microfounded model fails to explain any one of the things it purports to explain, you have to conclude that the model is flawed, and look for a better model. (In practice of course, not everyone actually does this when they ought to...)
Anyway, it's always valuable and fascinating to read Lucas' thoughts. I seem to agree with him on quite a number of important things, though not on issues related to the assumptions or the value of the RBC modeling paradigm...Not that many people especially care whether I agree with Bob Lucas, mind you, but hey, it's my blog!
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