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Looking Back in the New Year
On New Year’s Day, we look back at the decisions we made during the year and think what could have been if we chose differently. However, economist R. Lucas warns us to not be too hard on ourselves.
When we look back at decisions that we or others made, we often assume, especially if something did not work out, that if we had made a different decision, the outcome would have been beneficial. We also often think about this in the context of rooting for sports teams, especially with the recent World Cup coming to an end. If only the player made a different decision or if he had scored that goal, what could have been.
In a 1976 paper, future Nobel Prize winner Robert Lucas permanently altered how economists evaluated macroeconomic policy experiments. He argued that it was wrong to predict the impact of changing economic policy using only the relationships found in historical data, especially macroeconomic data (such as GDP, inflation, unemployment). By changing economic policies, one cannot assume that all economic participants (individuals, firms, governments) would act in the same way as before. Thus, it was crucial to actually model the decision making of individuals, as only then would we be able to evaluate the impact of changes in economic policy by taking into account how they would actually respond to this new economic policy. This critique of evaluating policy changes is now referred to as the ‘Lucas Critique’.
To illustrate the Lucas Critique, let’s look at an example from Tim Harford’s book, which asks the question how much should Fort Knox spend on security. Fort Knox, where the US stores a significant part of its gold reserves, has never been robbed. Any statistical analysis on the data would show that the spend on security does not impact the likelihood of a robbery.1 Thus, Fort Knox could significantly reduce its spending on security and guards. However, potential Fort Knox robbers might not have tried to break in because the ‘cost’ (i.e. likelihood of getting caught and punishment) was too great when security spending was high. With reduced security spending, which could reduce the chance of getting caught, it might have become beneficial to break in for the potential criminals. Therefore, altering the policy would, using historical relations in the data, not have any bad outcomes, but in reality it might be a terrible idea.
Failing to Account for the Lucas Critique
There are numerous historical examples that have shown the importance of taking into account the Lucas Critique when making decisions, as failing to do so can even make things worse. A famous example is called the Cobra Effect. A German economist, Horst Siebert, recounted a situation in India during British Rule, where the colonial authorities wanted to reduce the population of deadly cobras in Delhi. The authorities proposed a bounty for each cobra brought to them. However, soon a new business of cobra farming emerged that would raise cobras just to kill them and bring them to the authorities for the bounty. Once the British authorities caught on to this scheme, they abandoned the bounty system, which made it no longer worthwhile for the cobra farmers to operate. The cobra farmers released all the cobras they had, which resulted in a higher cobra population in Delhi than prior to the bounty scheme.
Numerous such policy failures have occurred all over the world. Another example was a United Nations plan to cut down greenhouse gas emissions, which offered cash to companies that would destroy a particular environmentally harmful greenhouse gas, a byproduct in the production of a commonly used coolant liquid. Companies soon started to increase the production of the coolant just to destroy the environmentally harmful byproduct, as they found it profitable. The program, which was introduced in 2005 by the United Nations, was scrapped in the European Union in 2013.
The Lucas Critique needs to be factored in when assessing any future policy changes. For example, zoning laws are often criticized for restricting housing supply, as the laws prohibit the construction of high density housing. Many economists and policy makers argue against them, believing that their removal would immediately improve the housing supply situation. However, in situations where there are no regulations, homeowners tend to organize themselves together (often referred to in the US as Homeowners Associations or HOAs) and impose a variety of rules, creating ‘private zoning’ laws that reduce housing. Thus, the removal of public zoning laws might not necessarily lead to an increase in housing. Similar questions can be asked of a variety of economic issues - what would be the impact of universal basic income, having a higher inflation target, higher or lower speed limits or, covered here recently, the impact of increasing student debt forgiveness.
In the New Year, when evaluating our own past decisions, it is important to remember that if we had made a different decision, everyone around us might have also acted differently, resulting in the same outcome. A common such discussion can occur in sports - in the World Cup match between the Netherlands and Argentina, in the final minute of the match with the score 2-1, the Dutch had a freekick opportunity. One Argentine player chose to lie on the ground, potentially blocking a low shot. By doing so, a Dutch player was left unmarked. The Dutch, instead of shooting, chose an intricate pass to the unmarked player, who scored, tying the game. Many thought that the Argentine player who chose to guard against the lowshot, should have instead marked the Dutch player. But if that had occurred, the Dutch may have gone for the low shot, scoring the goal.
I’ll finish this post with a funny a tweet showing the Lucas Critique visually. Happy New Year!
Since there were never any robberies, statistical analysis would find no impact of security spending on robberies.