Friday, May 19, 2017

The Lucas critique and Heraclitus's river

In Vast literatures as mud moats, Noah Smith mentions the Lucas critique. As described in Wikipedia:
The Lucas critique, named for Robert Lucas's work on macroeconomic policymaking, argues that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. More formally, it states that the decision rules of Keynesian models—such as the consumption function—cannot be considered as structural in the sense of being invariant with respect to changes in government policy variables.
I would argue that the Lucas critique is, consciously or unconsciously, derivative of Heraclitus and has broader application than just economics. In fact, I think the scope is any complex, dynamic system subject to unpredictable external shocks and internal evolution. In other words, it has application to any human system: economics, politics, diplomacy, sociology, language, business, finance, etc. Anything that involves a person as a constituent of the process.

Heraclitus of Ephesus captured this with his more abstract:
πάντα χωρεῖ καὶ οὐδὲν μένει
Everything changes and nothing stands still.
and his more concrete:
δὶς ἐς τὸν αὐτὸν ποταμὸν οὐκ ἂν ἐμβαίης.
You could not step twice into the same river.
Any decision you make in a dynamic system changes at every instant. Every decision is necessarily unique. Your priorities change over time, the system itself evolves, constraints change, additional factors are added, there are different levels of uncertainty, different risks, etc.

A concrete example: You buy your first house when you are thirty and single. When you are forty and married with children, you buy and move into a second home. Is the decision-making process of buying a house the same? I would argue (with Lucas and Heraclitus) that the answer is no.

Nominally this looks like the same decision but it is not. You cannot simply recapitulate the first process. You have a spouse whose interests have to be taken into account, children in the home introduce a different risk awareness, the external market has changed, your income has changed, the mortgage market has changed, you have the experience (and lessons learned) of already having bought a house, etc. What looks like the same decision is not. You are not stepping into the same river.

We are rational beings and we want to recycle as much as possible and that works for static systems. You do something once and then you keep doing it the same again and again.

It does not work for dynamic complex systems and it warrants separating the two categories.

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