David R. Henderson  

Bob Lucas's Talk

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Bob Lucas's talk at the Council on Foreign Relations is well worth reading. Here are some of the nuggets.

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.


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COMMENTS (13 to date)
Greg Ransom writes:

Robert Lucas is simply ignorant of the most significant parts of economics, e.g., capital theory. A sad but indisputable fact.

Lucas writes:

"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."

Tom writes:

"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?" "

In this case, I think the reason why it will take "political" courage is that, and we will see if this is the case, the Federal Reserve is not as independent as one thinks. Politicians will want to put pressure on the Federal Reserve not to raise interest rates and reduce the money supply right when the economy starts recovering. The politicians will fear that the Fed will cause the economy to go back in to recession if it does this. However, if politicians get their way, then inflation will become a big problem. Politicians will be the ones who need the courage not to put pressure on the Federal Reserve when it begins reducing the money supply.

ionides writes:

Based on text-book macro, I think these are the possibilites. The government prints money and:
1. buys goods. lm and is curves both shift right. output increases and interest is stable.
2. buys bonds. lm curve shifts right. interest rate falls, and output increases.
3. drops it from the sky and recipients buy goods. rightward shift of is and lm. output increases and interest is stable.
4. drops it from the sky and recipients buy bonds. lm curve shifts right. interest rate falls and output increases.
5. drops it from the sky and recipients stash it away. this is an interesting one. is this income? i don't think so; there is no addition to national output. precautionary balances rise. money supply and demand both shift right; interest stable; no effect on is or lm.
6. variation on 5. new money is put into speculative balances; this would probably combine with 4: the new money would be divided between bonds and cash. lm curve shifts right; increase in output. (note that if recipients put the new money in transaction balances, that would amount to number 3).

To sum up:
Lucas' argument: monetary policy increases spending with our without simultaneous fiscal policy: 1, 2, 3, 4, 6, not 5. the effects in 2, 4, 6 are second round.

RL writes:

Why do you need to put "political" in front of "courage"?

Because otherwise you wouldn't have an oxymoron.

David R. Henderson writes:

I agree with what Tom says above, but it doesn't explain why you need "political" in front of "courage."
RL, on the other hand, is the first of the commenters to try to answer my question. I do think, though, that occasionally a politician is courageous. So maybe RL helped get us to the answer I'm seeking: not that "political courage" is an oxymoron, but that courage in politicians is so rare that we think we need to have a separate category for it. In other words, it's almost an oxymoron.

Tom writes:

If the economy turns around by the end of this year, won't the proponent of the fiscal multiplier declare victory over the opponent of the multiplier? Won’t the Democrats and Obama administration jump quickly to the conclusion (with very little evidence) of the success of fiscal policy?

I think those who oppose the fiscal stimulus and the question the effectiveness of the fiscal multiplier should be prepared for the victory celebrations on the side of the proponents once the economy recovers. And the opponents should prepare in advance a proper response to the propaganda campaign that inevitably will come.

Adam writes:

"In my opinion, the fiscal "stimulus" is like the Bush decision to invade Iraq."

Exactly, another example of how government increases power by manipulating fear. To paraphrase President Obama's Chief of Staff, 'never let a good crisis go to waste!'

Joe Calhoun writes:

Tom,

My biggest fear...

Monetary policy will do the heavy lifting and the politicians (and Keyensian economists) will break their arms patting themselves on the back for enacting the stimulus plan.

It's also why I think the Republicans may be in much deeper trouble than they realize. If (when) the economy recovers, the Democrats get credit regardless of how or why it happened.

Niccolo writes:

I agree with Lucas' words, but not with the whole of the implications of his statement.

He's right to say that a modern economy cannot sustain deflation, but it would be no worse than economy in a period of inflation.

The key is not to tip the balance of equality to the left or the right, it is to attain and retain general equilibrium, which requires a stable money supply growing with demand so that monetary effects on prices are no more than -2% to 2%.

Greg writes:

Isn't the monetary versus fiscal policy point a bit disingenuous? Fiscal policy is when no one is going to build the bridge unless the government does it, and there are underutilized resources sitting around. I have my doubts about fiscal policy, but the bridge characterization is a strawman.

As far as the Iraq war and the fiscal stimulus both being a rush to action, sure. But why is it that the right is criticizing the stimulus and the left criticized the war?

Greg writes:

To put a finer point on my last comment, why are so many conservatives outraged that the government is spending their money on the stimulus but fail to be equally outraged that the government is spending their money on bombs, not for defense but for agression, not to mention sending US citizens to die and killing thousands of foreign civilians?

I realize I'm beating a dead horse, but it continues to astound me.

VangelV writes:

"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."

Let me defend this statement, even though I disagree with the author's approach. The way I see it, Lucas admits that the 'modern economy' is highly leveraged and based on the expectation of continual credit expansion. As such, a fiat based fractional reserve banking system and the Ponzi economy that they support cannot survive deflation.

The bottom line is that there is nothing wrong with deflation in a system that is based on hard money but the math does not allow a leveraged financial system to survive deflation in the fiat world that we live in.

Before someone takes a shot at my argument let us look at a scenario in which deflation is permitted.

Let us begin by supposing that the Fed and Treasury stand aside and permit the supply of money and credit to contract. With less money available the banks have to write down the value of assets that are currently on their balance sheets. But given the leverage in the system there is no way for the banks and brokers to survive those write downs.

Who benefits from such a contraction? Well, it is the creditors that have made loans to the federal government and see their purchasing power increase as the economy is melting down around them. That would allow the Chinese and other foreign holders to step in and purchase American owned assets that are being liquidated at fire sale prices. It is obvious that in this scenario that default is not an option because if the US government failed to pay off foreign bond holders the day of the USD as a reserve currency (or a viable currency) would be over.

Where is the incentive for such a deflation to be permitted in a world where printing presses can create purchasing power out of thin air at no cost to the issuers of the currency? Clearly the Chinese, Japanese, Koreans, etc., lenders don't get a vote and members of Congress are more interested in short term actions that will allow them to get re-elected.

Sorry but this ends in a massive exercise of money printing and inflation. Sadly, that means that the days of the USD as a strong currency with relatively stable purchasing power are long gone. All fiat currencies wind up being valued at their intrinsic value and the USD is likely headed toward zero even faster than it has been since Nixon took the country off the gold standard.

David R. Henderson writes:

Greg wrote:
To put a finer point on my last comment, why are so many conservatives outraged that the government is spending their money on the stimulus but fail to be equally outraged that the government is spending their money on bombs, not for defense but for aggression, not to mention sending US citizens to die and killing thousands of foreign civilians?
I realize I'm beating a dead horse, but it continues to astound me.

My response: Me too. Conservatives like Robert Taft would have been strongly opposed to these wars.

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