The basic flaw in all economic modelling


The Lucas Critique is summarised by Mark Buchanan as follows:

Any prior regularity that might have existed in a set of data had been present only in the context of the policies prevailing in the past. Change the policies and those changes, by influencing the way people act and anticipate the future, may well strongly change or destroy the regularity on which you had based your plans.

In economics this observation was made famous by Robert Lucas in this 1976 article.

Lucas’ critique has justified the micro-foundations approach to macroeconomics for four decades. Put simply, unless you model the macro economy as a result of ‘deep parameters’ of the human psyche, you will never be sure whether your model will apply in a different regulatory or institutional environment. Overcoming the Lucas Critique is apparently achieved by offering a macroeconomic model that stems from a utility function of a representative agent.

But why should we believe that the ‘deep parameters’ of micro-foundations, the utility functions themselves, are somehow independent of the institutional environment?

You can’t escape Lucas’ critique by plucking a utility function out of the air and giving it to a representative agent unless you believe that utility functions are independent of the social environment.

Which raises the question, how can it be possible for an individual’s preferences, their utility function, to arise in a social vacuum?

It can’t. The evidence is absolutely clear on this point. Preferences, and even perception, are socially constructed. There simply are no ‘deep parameters’.

The whole micro-foundations exercise has been a waste of time for all involved.

While economics has taken seriously this critique from Lucas, they have generally ignored its logical extension of the performativity of economic analysis. Basically performativity says that the use of an economic model in society to guide decisions itself changes behaviour, thus changing the environment in which the analysis applies. Or more simply, utility functions with change in response to the use of models built upon utility functions.

The easy way to see this in action is in sports. As soon as one coach creates a play that exploits a common behaviour in other teams, using that play changes the other team’s response, and thus the environment in which the coach’s original analysis was relevant.

You can’t escape any of this logic.

The lesson is that to understand economic phenomena requires a better understanding of institutional environments, and historical and social context. The micro-foundations approach has merely been an excuse to continue to conceptualise the economy as self-stabilising and in equilibrium in the face of the Lucas Critique, while any rational response would have been to acknowledge the inherent instability of social processes, of which the performativity of economic analysis itself a part of.

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    • Before the term “economics” was invented, some philosophers wrote on the subject of “dialectics” and it is very apropos to understanding economics properly.

      I think it is a lot more credible to throw up our hands in despair and accept that economies are too complex to model, than to adopt the conceit that we can do it. This conceit has done far too much damage to humanity already.

      There are simply so many actors who will all respond in different ways to different inputs, and the way each one responds will affect the others as well.

      We can accept some principles as representing “nudges” to people’s behaviour, and try them out and see what happens. For example, this is why fiscal incentives regarding energy use are far more use than blunt-instrument urban planning. Anthony Downs put it beautifully when he said that trying to reduce energy consumption by imposing urban form by mandate is like trying to shift the position of a picture on a wall by moving the wall rather than the picture.

  1. Agree that using alleged micro-foundations is a trap. One of the problems, almost never addressed, is that there is such a huge variety in individual preferences. Trying to construct a demand function from the behaviour of a “representative consumer” is just plain fallacy – almost always we are actually constructing this mythical being from the observable demand function.

    It was always absolutely crazy in just about every respect, as well as immensely presumptuous, to try to change peoples energy usage by mandating urban form. You want to change their energy use you need to do something about energy – is that so hard to understand?

    Anyway – it’s not why they changed urban form, the environment was just a post-hoc rationalisation. They did it because they were starved of infrastructure money and jurisdictions had no incentive to increase populations.

  2. Economics is just another name for sociopolitical theory, of which, 99%ish is grounded in synthetic a priori and ex nihilo axioms from from antiquity do to lack of decent data.

    Ergo what is human nature and what is the best way to organize society. Sadly some doctrinaires are institutionally conditioned and confuse dogma as a form of intellectualism, rigidity as seeking and adaptive cognitive exercise et al.

    Skippy…. most of it is just esoterica echoing through history.

  3. I think we place too much emphasis on the on the monetisation of measure in economic analysis which is why I go for things like L2C measures.

    The extension of that is a view that perception of economic utility expressed in market to the extent that it represents a variance to underlying utility is an economic distortion, legitimately to be seen as a loss to optimality by default.

  4. Attempting to model something that is inherently too complex to model, and then drawing spurious conclusions which have far reaching societal and economic consequences has long been a favoured folly of academics, and isn’t likely to stop any time soon.

    Just look at the AGW fiasco.