The Lucas Critique

Robert Lucas is an economics professor at the University of Chicago and the 1995 winner of the Nobel prize in economics. His work is foundational in behavioral economics, New Keynesian economics, and micro-economic based macro models. He is one of the most influential economists since the 1970’s.

One of his principle contributions was to challenge the way people create macro-economic models. There is an obvious flaw in the old way. Essentially that flaw is that once you notice that two conditions are correlated, if you change something to take advantage of the fact, the correlation will go away.

That makes your own plans more difficult too. After all, your personal financial plan is your macro plan.

Everyone can use “The Lucas Critique” to understand their personal situation more fully and thus be able to predict better and observe alternate behaviors that may have a greater expectation of success. It says:

“Given that the structure of an econometric model consists of optimal decision rules of economic agents, and that optimal decision rules vary systematically with changes in the structure of series relevant to the decision maker, it follows that any change in policy will systematically alter the structure of econometric models.”

Note: 1) Economic agents are individuals, businesses, public institutions, governments and central banks. 2) Series relevant to the decision maker are the rules, outcomes and their effects.

That means if you change a rule in the system, the old outcomes will not necessarily reappear. The old results were not based completely on foundational facts but rather were the outcomes of the “optimal behaviors” that occurred under the old rules. Change the environment; change the behavior; change the outcome.

You won’t know in advance and with certainty what new “optimal behavior” will occur.

The result for policymakers of any stripe is that experience may lie. Experience is contextual. You cannot base strategic decisions on observed results unless you know, with certainty, that all of the underlying conditions of the observed results will still be present. If part of your plan is to change the underlying rules or relationships, then you guarantee that the old results are in a different context than future results. The future outcomes may vary wildly from predictions.

For example

  1. Doubling the tax rate does not double the revenue.
  2. Doubling minimum wage does not double the income of those earning minimum wage
  3. There is a tight negative correlation between inflation and unemployment, but if you try to eliminate unemployment by raising inflation, the correlation will disappear.
  4. Changes in the value of stock markets used to be highly positively correlated with the volume of shares traded. With the advent of high velocity trading, that correlation has ceased to exist.
  5. Adding an asset, like a second home, adds operating costs.
  6. Two children cost more than one and not just in money.

The moral. Neither overvalue your experience, nor overvalue historic results. They may be based on a set of circumstances that no longer exists and will therefore be worse than useless. Even dangerous. Can you trust what you think?

Be objective. Notice fundamental change and act sooner. The old ways tend not to come back once the fundamentals change. Reliance on old results in a new system is the basis for the law of unintended consequences.

Always ask, “Okay, what then?”

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.  |  Twitter @DonShaughnessy  |  Follow by email at moneyFYI

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