In defence of Lucas '72.
Take any macroeconomic model of a market economy with inefficient aggregate fluctuations. In fact, take any economic model where something bad might happen.
Assume that model is literally true.
The people in that model are idiots.
This conclusion follows immediately. If they weren't idiots, the people in the model would appoint the economist modelling the economy as central planner, who would tell them all what to do, and make them all better off.
The people in Lucas' '72 model are complete idiots for producing less because they don't realise there's a recession on.
The people in New Keynesian models are complete idiots for waiting for the Calvo fairy to give them permission to cut prices in a recession.
All models suffer this same problem. If the world really were as simple as the economic model of that world, people would figure it out, and wouldn't let bad things happen.
It's unfair to single out Lucas '72 for this criticism. Actually, it's doubly unfair, because Lucas did at least address this question, and carefully rigged up the assumptions of his model so that the people in it wouldn't be able to figure out that there's a recession on. Was that a satisfactory answer? Not really, because most people do read the news, and know there's a recession on. But at least Lucas gave an answer.
The map is not the territory. All models are simplifications of reality. They leave masses of stuff out. That's what makes them models. That's what makes them (potentially) useful. But it's also what makes any model of a market economy self-contradictory. If the economy really were that simple, people wouldn't need markets to resolve the Hayekian problem of the coordination of the changing plans of multiple people, each with their own local knowledge.
All real world markets, even the simplest, are more complicated than any economic model of a market.
Take the housing market for example. If I wanted to model it, especially in a macroeconomic model where all complications get squared or cubed when we add them all together, I would use something like a simple demand and supply model. But at the same time I would know that's hopelessly oversimplified.
Suppose you decide to sell your house. You know that your house is different from other houses on hundreds of dimensions that might matter to a potential buyer. You also know that each potential buyer is different, and evaluates each of those dimensions differently from any other buyer. When you post a price, and when you decide whether to accept an offer, or make a counteroffer, you know you face a trade-off between getting a quick sale and waiting for a better price. And each potential buyer faces a trade-off between buying your house now or waiting for a better price or a house that suits him better. And the trade-off facing one seller, and the trade-off facing one buyer, depend on the choices that will be made in future by all the other potential buyers and sellers, which depend in turn on their perceived trade-offs.
That's an incredibly complex market. And I'm sure I've left a load of stuff out.
The labour market is even more complex than the housing market. All that matters to the person selling a house is the price and when he sells it. (OK, that's an oversimplification). The person selling his labour has to think about where he will be spending half his waking hours for the next few years, or decades. And I'm sure I've left a load of other differences out too.
Start in equilibrium (whatever that means in a housing market like I've just described). Now imagine that there's a tightening of monetary policy. What happens?
"God only knows" is the short answer.
Look, monetary economists can't even agree on what "monetary tightening" means. How do you expect the average home seller or buyer to understand it, even if they do all read the newspapers?
In a very simple model of the housing market, and if all markets were equally simple, and if everybody understood monetary policy, I know what would happen. The demand curve would shift left; the supply curve would shift right; and the nominal price of houses would drop in proportion to the drop in the money supply.
At least, that's what I think would happen, but I bet some people reading this will already disagree.
And I'm fairly sure, but not 100% sure, that something vaguely similar to this would happen eventually. After all, for any equilibrium there ought to be another equilibrium where all the monetary units are changed but all the things measured in real units are the same. I'm not 100% sure because there might be more than one real equilibrium.
But in a real world housing market, like the one I have sketched above only more complex, where most people don't understand what's going on, and their mistakes will affect the trade-offs facing other buyers and sellers, and so affect their behaviour, which again affects those trade-offs, and leads to more mistakes…..? I don't know what's precisely going to happen. Nor does any other economist. And, more importantly, the buyers and sellers in that housing market, and all the other markets that interact with that market, won't have a clue what's really happening and what their optimal response should be.
The signal-processing problem facing real buyers and sellers in a real market are massively more complex than the signal-processing problem faced by agents in Lucas' model in a perfectly competitive market of a homogeneous good.
"It's taking me longer to sell my house than I thought it would. Am I pricing too high? Did I just get unlucky, and the person who really wants to buy my house and is prepared to pay my price just happens to be coming a little later than normal by sheer chance? Has my trade-off between getting a quick sale and getting a high price gotten flatter or steeper?"
And potential buyers are asking similar questions.
And no economist knows the answer to those questions, so you can't expect the buyers and sellers to.
That's even before you throw in something like menu costs of changing prices.
Suppose recessions lasted 1 week. If they did, I think most economists would have a very different view of Lucas '72. "It takes people 1 week to figure out there's a recession on and how to react? Sounds plausible."
Suppose recessions last 100 weeks. "It takes people 100 weeks to figure out there's a recession on and how to react? Sounds totally implausible."
But maybe real world markets are 100 times more complex than the simple demand and supply model. And maybe the signal-processing problem is 100 times more complex than in that simple model. And maybe it takes people 100 times longer to figure out how to react, when one person's reaction depends on everyone else's reaction. That sounds plausible to me.
We draw a supply and demand curve and point to where the two curves cross. We shift the supply and demand curves and point to where the two new curves cross. The only people who talk about the process of getting from the first point to the second point are: teachers of Economics 1000; Austrian economists.
Maybe it takes time to get from the first point to the second point. Not because people are idiots, in not changing their prices, or not figuring out what's going on and how to react. But because the territory is a lot more complicated than the map.
And it's always going to be hard to build a map of how the territory is more complicated than the map.
Worthwhile Canadian Initiative 
Warning. This comment is rude. I have been as polite as I can force myself to be.
I reject your alleged proof. You assume that a benevolent social planner is available.
I think that market outcomes are inefficient. I don’t want to appoint a dictator. I may or may not be an idiot, but the conclusion that I must be an idiot doesn’t follow.
Consider crime. We don’t like crime. We ban it. We have police and stuff. We have crime. This isn’t because we are idiots. There are two reasons. there are enforcement problems with command and control solutions (even if the command is “don’t kill each other”). Also dictators are dangerous. We can’t count on their benevolence.
Your assertion doesn’t even follow in the imaginary world of Lucas 72. Lucas’s model does not include a benevolent agent who is able to make suppliers supply. It isn’t there. You have modified the model fundamentally changing it, then assert that the result for your new model holds for Lucas’s model.
I have two questions
Do you seriously believe what you typed at the beginning of this post ?
and
How could anyone type such a thing ?
Your conclusion, that models are misleading just because they are (and should be) simple and the world is complicated is a very good point. This is definitely true. It is important. The always implausible hypothesis of rational expectations is much more appealing if the model with which expectations must be consistent is simple enough to solve.
I think this would be an excellent post if the first seven sentences were deleted (so it would start with “The people in Lucas'”). But those sentences are nonsense.
As an aside, nominal rigidities and price prediction errors are not at all needed for Pareto inefficient outcomes. Market outcomes can be Pareto efficient even if people have perfect foresight and all markets clear (consider pollution externalities).
To belabor the totally blindingly obvious fact that your assertion is false.
You claim that, any day we wish, we could have, for example, perfectly efficient regulation of polution. Just walk down any street (in the USA and Italy anyway) and see how there is no litter. All at the low low perfectly efficient zero cost of enforcing anti littering laws. You confidently assert not only that there ought to be a law, but also that the law will work perfectly (not well perfectly) unless the legislators are idiots.
I ask for information. How could you have written something so obviously false ?
I’m pretty sure that people who are using this post as a springboard for righteous wrath are missing its point.
More generally, anyone wishing to use WCI as a springboard for righteous wrath are invited to jump in other parts of the internet. It’s a big place; there are plenty of outlets for it.
sigh
Last comment was not an invitation to explain why your righteous wrath is justified.
Robert Waldmann: “I have two questions
Do you seriously believe what you typed at the beginning of this post ?
and
How could anyone type such a thing ?”
I have the image of an irate schoolteacher glaring down at a 5 year old.
Knock it off. I can’t stop you acting like that on your own blog, but as Stephen said, it’s totally out of place here.
And you might want to reconsider the whole irate ursine act in general. History is littered with angry people doing stupid and evil things because they believed anyone who disagreed with them was stupid or evil.
And thinking about that, and your comment, makes me angry too.
Perhaps what I said at the beginning of this post isn’t as clear as it should be. Perhaps it’s wrong. But stupid?
Suppose you have a model in which bad things happen, and you think things could be better. I can think of three cases to which all such models might ultimately be reduced:
1. Prisoners’ Dilemma. So, what are you going to say? “If you guys would only cooperate, you would both be better off”? If they could cooperate, it wouldn’t be PD.
2. Stag Hunt. Again, what are you going to say? “When I give the word, both of you switch from hunting hare to hunting stag.” Couldn’t they say that themselves?
3. A maze. You, as modeller, have some sort of bird’s eye view, and can see the route out of the maze, which the players themselves can’t. OK. Maybe in this case you can say something useful. But if the maze is simple enough for you to model, it ought be be simple enough for the players themselves to model, and figure their own way out.
My gut says that the maze might be the best way to think of what economists do, as an advice-giving profession. After all, someone’s got to be the first person to figure out the maze. And it might be one of us. But there’s still a tension here. If the maze is literally as simple as our model says it is, how come the people stuck in the maze haven’t figured it out already?
Yeah, of course. But some modeling approaches are better at their jobs than others.
“Start in equilibrium (whatever that means in a housing market like I’ve just described).”
Imagine if climate scientists used static “equilibrium” models like this. Sheesh. Is a warm sunny day at some point on the earth in “equilibrium”? A rainy day? A blizzard? How about 100 miles away? Kind of a meaningless question. Arguably a useless approach to modeling. (Hell, we don’t even know what direction the IS curve slopes.)
The only working dynamic model (assuming there is no imagined “equilibrium,” only constant change) that I know of is Steve Keen’s. You can download it and run it. (He’s developing a new version, web-based.) It’s pretty simple compared to climate models, but it seems to have some predictive power, and it certainly has some illuminative power.
http://www.debtdeflation.com/blogs/qed/
Some guys at Santa Fe Institute, last I heard, were “hoping to” develop such a model. I hope they put it on the web where we can run it through its paces.
Shouldn’t there be dozens, hundreds of top-flight people trying to build these models? I corresponded with a young PhD candidate who wanted to work on one, he said all the institutional systems conspired to prevent it. “Just grab a data set and throw some regressions at it. Build a static equilibrium-based model to theorize the results. Collect PhD.”
Steve Roth: you have been very badly misinformed. (By who?) Google “DSGE”.
Calling a model “dynamic” doesn’t make it so. Here’s some overviews of DSGE models:
http://cscs.umich.edu/~crshalizi/notabene/dsges.html
http://robertvienneau.blogspot.com/2010/11/slight-illness-doctor-jests-king-today.html
Nick Rowe would have done better to refer to Agent-Based Models (ABMs). I like some work Ian Wright has done with them.
Robert: they are “dynamic” in the sense of having an equilibrium in which the endogenous variables move over time, as opposed to a “static” equilibrium. And, DSGE models are common. ABMs are relatively rare. Since Steve was talking about what economists do, DSGEs give a better typical picture. But yes, one could add ABMs as well.
I expect you could make a case that ABMs are one way to try to tackle the main point of this post?
The Arrow-Debreu model of intertemporal equilibrium is a static model in which all agents have their plans for the future pre-coordinated at a single instant of time. Despite the model being static, relative prices differ for forward trades of different dates.
Robert Shiller pointed out in 1978 that RBC modelers don’t take seriously out-of-equilibrium behavior and the question of how equilibrium is established. As far as I know, Shiller’s point remains true for DSGE modelers.
Steve Roth is correct in thinking that mainstream economics typically suppress modeling of economic dynamics.
What point? I agree with Robert Waldmann that it is silly to think that just because a model shows a suboptimal equilibrium, the agents must be either idiots or be able to establish an optimal equilibrium, perhaps with a dictatorship.
Robert: “As far as I know, Shiller’s point remains true for DSGE modelers.”
I think that is correct too. Trouble is, what does “equilibrium” mean? It doesn’t mean “point of rest”; it doesn’t mean (or have to mean) “supply=demand”. If you had a model which showed how (say) P and Q moved over time from one supply=demand equilibrium to another, wouldn’t you want to say that the time paths of P and Q in your new model were an “equilibrium” of that model? In other words, “equilibrium” means “whatever the model says will happen”.
In an ABM, “equilibrium” means “the time path traced out by your computer”?
We might follow Hayek, and define “equilibrium” as when agents plans are mutually consistent. And “disequilibrium” means agents are changing their plans because they discover their plans are mutually inconsistent. But even here, if agents make a contingent plan, depending on what others do, they aren’t really changing their plans, just following different paths of that plan, according to how events unfold.
Robert: “What point? I agree with Robert Waldmann that it is silly to think that just because a model shows a suboptimal equilibrium, the agents must be either idiots or be able to establish an optimal equilibrium, perhaps with a dictatorship.”
Then you are missing my point. At the risk of having more enraged people piling on again: my point is not about the world; it is about modelling the world. Yes, bad things happen. And we should try to make them better. Maybe with the help of a model. We have models showing bad things happen. Does the model show how to make things better? If it does, then why haven’t the agents already figured it out themselves? Maybe it’s too complex for them? But if your model is simple enough for you to understand, and if the model were literally true, why can’t they understand it, unless they are less smart than you? Maybe the answer is that models aren’t literally true and are simpler than the world they describe, so it’s easier to figure out what’s wrong in the model than to figure out what’s wrong in the real world?
“If you had a model which showed how (say) P and Q moved over time from one supply=demand equilibrium to another, wouldn’t you want to say that the time paths of P and Q in your new model were an ‘equilibrium’ of that model?”
No, not necessarily.
“We have models showing bad things happen. Does the model show how to make things better?”
Often, no.
@nick rowe
i think what you are missing is that agents don’t necessarily have the ability to optimize the functioning of a system, or at least an economic model doesn’t need to make that assumption. only from making this assumption can you come to the conclusion you have come to.
let’s take pareto optimality. there are two major problems with this, first losers don’t necessarily have the ability to enforce compensation from winners. second, only in a model that reaches equilibrium where agents have perfect information is this possible. let’s take my importer example from earlier. even if he has a mechanism to enforce compensation payments, how much can he demand and how much would actually compensate him. in a non-linear dynamic world, how does he know how much losses import quotas will put on him? would the winners benefit overtime as much as he loses? how do we know that? how is it even possible to calculate?
Allow me to play Devil’s Advocate for a moment: is the “people are stupid” explanation really so wrong? After all, economists also make stupid mistakes: the ECB is bragging—bragging!—about how the Euro only experienced 1% inflation while in the midst of a debt crisis. The solution is simple and obvious: if the ECB targeted 5% inflation every year for the next 5 years, the debt crisis would be mostly over (Greece would probably still be in trouble, but that’s it).
But it is not done. The debt crisis could be over, if the ECB wanted it to be, but it doesn’t. Considering the bragging it did, stupidity seems the only option.
So is it any surprise that regular people have difficulty doing the easy solution, when the ECB can’t do it either?