Lucas critique

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The Lucas Critique says that it's naive to try to predict the effect of a policy experiment based on correlations in historical data, especially high-level aggregated historical data. For example, Fort Knox has never been robbed, but that doesn't mean we can safely eliminate the guards, since the incentive to rob Fort Knox depends on the presence of the guards. If we do want to predict the effect of a policy experiment, we must model the "deep parameters" (preferences, technology and resource constraints) that govern individual behaviour. We can then predict what individuals will do conditional on the change in policy.

The basic idea is old, but in a 1976 paper Robert Lucas drove the point home that this simple notion invalidated policy advice conditioned on the response of estimated system of equation models. Because the parameters of those models were not structural -- policy-invariant -- they would necessarily change whenever policy -- the rules of the game -- was changed. Any policy advice would then be meaningless. This argument sounded the beginning of the end of large structural models that lacked foundations in dynamic economic theory and strongly influenced Finn Kydland and Edward Prescott as they were writing their classic paper on time inconsistency.

The Lucas Critique was influential not only in casting doubt on many models of the economy but also in encouraging macroeconomists to build microfoundations for their models. Microfoundations had always been thought to be desirable; Lucas showed they were necessary. Later Finn Kydland and Edward Prescott would show how to use microfoundations to formulate macroeconomic models.