Lucas critique and DSGE models

I’ve seen the view that DSGE models fail the Lucas Critique come up a bunch in recent years, and nodded my head in agreement.  But I’ve never popped a post down saying it – so this speech by Plosser gives me that opportunity (ht Stephen Williamson).  I find it hard to disagree with this statement:

During the 1980s and 1990s, it was quite common to hear in workshops and seminars the criticism that a model didn’t satisfy the Lucas critique. I thought this was often a cheap shot because almost no model satisfactorily dealt with the issue. And during a period when the policy regime was apparently fairly stable — which many argued it mostly was during those years — the failure to satisfy the Lucas critique seemed somewhat less troublesome.

However, in my view, throughout the crisis of the last few years and its aftermath, the Lucas critique has become decidedly more relevant.

Policy actions have become increasingly discretionary. Moreover, the financial crisis and associated policy responses have left many central banks operating with their policy rate near the zero lower bound; this means that they are no longer following a systematic rule, if they ever were. Given that central bankers are, in fact, acting in a discretionary manner, whether it is because they are at the zero bound or because they cannot or will not commit, how are we to interpret policy advice coming from models that assume full commitment to a systematic rule? I think this point is driven home by noting that a number of central banks have been openly discussing different regimes, from price-level targeting to nominal GDP targeting. In such an environment where policymakers actively debate alternative regimes, how confident can we be about the policy advice that follows from models in which that is never contemplated?

Of course, the limits to reductionism for macroeconomics are quite harsh – especially if we fully accept the Cournot problem (computation from fully described individual agents to aggregates is impossible) and that macroeconomics “supervenes” on, but is not reducible to, microeconomics (see here).  Such limits to knowledge, and the fact that the Lucas Critique applies to our current “microfounded” models, implies that central banks should be conservative with their actions – and that expecting them to be able to (or that we can actually understand how to) fully deal with the ebbs and flows of shocks is a bridge too far.

Even given this, in truth macroeconomics still needs to be trying to understand the behaviour and structure behind any relationships they observe (or at least the behaviour and structure they are assuming when coming up with policy advice) – and this corresponds to the central research program of macroeconomics as it stands.  Many of us – me included in my weak moments 😛 – keep trying to find relationships that seem either theory or history invariant, where we can just either use the data or the concept and say “this is what will happen”.  While this is a useful heuristic, this isn’t what these macroeconomic scientists are (or should be) relying on!

Sidenote:  While putting up the link to the Hoover book I spotted this – I am buying this and I’m starting it tonight, damn it looks hot!  This of course means the review I was talking about yesterday will be further delayed …