Goodhart’s Law: Its Origins, Meaning and Implications for Monetary Policy

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Introduction By Chrystal & Mizen

Many distinguished economists have their name associated with some theory, concept or tool in economics. Obvious examples include: Giffen goods, the Pigou effect, Nash equilibrium, the Coase theorem, the Phillips curve, the Rybczynski and Stolper- Samuelson theorems, Ricardian equivalence, the Engle curve, the Edgeworth- Bowley box, Tobin’s q, and the Lucas critique. However, very few economists are honoured by having their name associated with a “law”. Charles Goodhart joins Sir Thomas Gresham, Leon Walras, and Jean- Baptiste Say in a very select club. In this paper we explain Goodhart’s Law and the context in which it arose, and discuss whether it has the qualities that will help it survive over time. Mainly this requires that it can be adapted to new circumstances as the world changes. Gresham’s law, for example, was invented to describe the problems that arose from the artificial fixing of gold and silver prices but it turned out to have applicability to a wider range of monetary regimes wherever currency substitution was possible. Dollarisation in Equador, and other countries, would be a contemporary example of ‘good money drives out bad’.

We shall focus particularly closely on the comparison between Goodhart’s Law and the enormously influential Lucas Critique. It could be argued, that Goodhart’s Law and the Lucas critique are essentially the same thing. If they are, Robert Lucas almost certainly said it first. However, while both Goodhart’s Law and the Lucas critique relate to the instability of aggregate macroeconomic relationships, we shall argue that there are significant differences. In particular, while the Lucas Critique has affected macroeconomic methods in general, Goodhart’s Law has been more influential in monetary policy design — monetary targets are out and inflation targets are in.

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