After pointing out that the forecasted rate of growth of nominal GDP for 2009 is zero percent, he states:
So if we don't change the rate of growth of nominal income, and we want to get a 5 percent real growth, we're going to have to have an offsetting deflation of 5 percent. And these things have to add up. And that's just not going to happen. It is not possible to pull a modern economy through a neutral or painless deflation. Economic theory doesn't really tell us why -- what's hard about it. But, the evidence, I mean, it just doesn't work.
This is an amazing statement from someone who made his reputation in the 1970s by arguing that if people came to expect a particular inflation rate (the same applies to deflation), they would correctly estimate relative prices (realizing that the relative price of their own product has not risen or fallen) and there would be no reason to adjust output. Bottom line: with correct expectations, we are at full-employment output. I hasten to add that I don't think less of Lucas for saying this: I think more of him. It brings to mind the quote attributed to Keynes: "When the facts change, I change my mind. What do you do, sir?"
Lucas then goes on to point out that once velocity recovers, the Fed, to avoid 1970s-level inflation, will have to be willing to reduce the money supply. This, he says, will take "political courage." I agree with him, but I've always wondered about that phrase: why does "political" have to be in front of "courage?"
Some clarity on monetary vs. fiscal policy:
If the government builds a bridge, and then the Fed prints up some money to pay the bridge builders, that's just a monetary policy. We don't need the bridge to do that. We can print up the same amount of money and buy anything with it. So, the only part of the stimulus package that's stimulating is the monetary part.
This is a point I've been making in my macro class. Who will spend the money on things that are most valuable: a government spending other people's money or people spending their own money?
Asked how he would apply "the Lucas critique" (of macro models) to the issue of the fiscal multiplier, Lucas answers:
Do I need the Lucas critique for -- I'm with Barro is the short answer. (Laughter.) The Moody's model that Christina Romer -- here's what I think happened. It's her first day on the job and somebody says, you've got to come up with a solution to this -- in defense of this fiscal stimulus, which no one told her what it was going to be, and have it by Monday morning.
So she scrambled and came up with these multipliers and now they're kind of -- I don't know. So I don't think anyone really believes. These models have never been discussed or debated in a way that that say -- Ellen McGrattan was talking about the way economists use models this morning. These are kind of schlock economics.
Maybe there is some multiplier out there that we could measure well but that's not what that paper does. I think it's a very naked rationalization for policies that were already, you know, decided on for other reasons.
I think Lucas put his finger on how quickly governments, Republican or Democrat, make even big decisions: quickly, with very little evidence, and often with rationales cooked up after the fact. In my opinion, the fiscal "stimulus" is like the Bush decision to invade Iraq.