Saturday, April 25, 2009

Government Failure: Willfully Ignorant Economic Policies

This passage on the Lucas critique in the Monetary Economics textbook by Champ and Freeman discusses a very important economic lesson that many policymakers around the world have chosen to ignore during this crisis, especially policymakers in our current administration (italics are mine):
The importance of the Lucas model lies not primarily in its explanation of the money/output correlation, as interesting as it may be. ... Lucas's paper changed macroeconomics by demonstrating that the correlations among macroeconomic aggregates are subject to change when economic policy changes. This showed macroeconomists the pitfalls in evaluating policy by looking simply at correlations in the data, without a working theory of how people may react to policy changes. Those macroeconomists who open their eyes to Lucas's critique are thereafter compelled to fully specify the environment in which the economic agents studied make their decisions.
The disturbing lack of understanding by current policymakers of the lesson above is one of the main reasons why so many economists have been critical of the economic policies adopted by the current administration. The cost of this willful ignorance will surely not be small.

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