Robert Lucas and Monetary Policy

Required reading in the current financial crisis is Robert Lucas’ recent editorial in the Wall Street Journal: Bernanke is the Best Stimulus Right Now. As can be expected from such a great intellect, the editorial is well-written and cogent. I agree without reservation on his key points: the zero bound is meaningless for the conduct of monetary policy and the Fed can solve liquidity crises at will. His seeming certainty, however, over the effectiveness of monetary policy is at odds with his earlier writings in which he is unsure if monetary policy can stimulate output.

The first two paragraphs combined with the last contain the main elements of Lucas’ intellectual argument for monetary policy as stimulus. The remainder of the article deals mainly with the implementation of the spending. Lucas has apparently also noticed the burgeoning balance sheet of the Federal Reserve (see this note).

I have abbreviated the key paragraphs here, omitting only details for the sake of brevity (I link to the editorial in its entirety above).

The Federal Reserve's lowering of interest rates … was also received with skepticism. Once the federal-funds rate is reduced to zero … doesn't this mean that monetary policy has gone as far as it can go? This widely held view was appealed to in the 1930s to rationalize the Fed's passive role as the U.S. economy slid into deep depression.

It was used again by the Bank of Japan to rationalize its unwillingness to counteract the deflation and recession of the 1990s. In both cases, constructive monetary policies were in fact available but remained unused. Fed Chairman Ben Bernanke's statement last Tuesday made it clear that he does not share this view and intends to continue to take actions to stimulate spending.

There are many ways to stimulate spending, and many of these methods are now under serious consideration. … But monetary policy … has been the most helpful counter-recession action taken to date … It is fast and flexible. There is no other way that so much cash could have been put into the system as fast as this $600 billion was, and if necessary it can be taken out just as quickly. …

These paragraphs give the impression of an intellect that is quite confident in the ability of monetary policy to simulate activity. There can be no question of the meaning or of the intent in these words: monetary policy has stimulated spending and reduced the severity of the recession.

In his 1995 Nobel acceptance speech (also required reading of any who would understand the intellectual issues of monetary policy), he quotes extensively from the various writings of David Hume, pointing out the potential inconsistencies in Hume’s treatment of money.

In the same spirit, I quote here from Lucas’ Nobel lecture.

The work for which I have received this prize was part of an effort to understand how changes in the conduct of monetary policy can influence inflation, employment, and production. So much thought has been devoted to this question and so much evidence is available that one might reasonably assume that it had been solved long ago. But this is not the case: It had not been solved in the 1970s when I began my work on it, and even now this question has not been given anything like a fully satisfactory answer. (opening paragraph)

In summary, the prediction that prices respond proportionally to changes in money in the long run, deduced by Hume in 1752 (and by many other theorists, by many different routes, since), has received ample - I would say, decisive - confirmation, in data from many times and places. The observation that money changes induce output changes in the same direction receives confirmation in some data sets, but is hard to see in others. Large scale reductions in money growth can be associated with large scale depressions or, if carried out in the form of a credible reform, with no depression at all. (the middle of page 252)

These two paragraphs give a distinctly different impression from those in the editorial. These are the careful and thoughtful words of an agnostic with respect to the efficacy of monetary policy. He is not stating that money does not boost output but he is also not convinced that it does. I admit that some years have passed since these words were written. Many things have changed over the 13 years that have elapsed and great progress has been made in monetary theory. Nonetheless, even if the data over this time period aligned perfectly with the idea that money can stimulate output (and it does not), 13 years is not sufficient time to completely change the empirical picture Lucas developed in his lecture. (This article from the St Louis Fed discusses the Nobel lecture further.)

Consistency surely requires at least an attempt to reconcile these disparate views. I don’t believe Lucas is unaware of his earlier work. Nor, do I believe that Lucas has somehow recently become convinced that monetary policy is automatically effective in stimulating the economy.

The following two paragraphs pulled from the middle of the editorial may shed light on this puzzle.

Why do I describe this as an action to stimulate spending? Financial markets are in the grip of a "flight to quality" that is very much analogous to the "flight to currency" that crippled the economy in the 1930s. Everyone wants to get into government-issued and government-insured assets, for reasons of both liquidity and safety. Individuals have tried to do this by selling other securities, but without an increase in the supply of "quality" securities these attempts do nothing but drive down the prices of other assets. The only other action people can take as individuals is to build up their stock of cash and government-issued claims to cash by reducing spending. This reduction is a main factor in inducing or worsening the recession. Adding directly to reserves -- the ultimate liquid, safe asset -- adds to supply of "quality" and relieves the perceived need to reduce spending.

Could the $600 billion in new reserves be called a bailout? In a sense, yes: The Fed is lending on terms that private banks are no willing to offer. They are not searching for underpriced "bargains" on behalf of the public, nor is it their mission to do so. Their mission is to provide liquidity to the system by acting as lender-of-last-resort. We don't care about the quality of the assets the Fed acquires in doing this. We care about the quantity of its liabilities.

I believe the certainty of Lucas’ belief stems from his certainty that the downturn is caused solely by a liquidity crisis—a flight to quality—that is preventing banks from lending and households and businesses from spending. If that were true, then the Fed would be stimulating output, not by boosting production or creating jobs, but by preventing a collapse that would send the global economy into a tailspin. All good economists believe that the Fed can easily resolve liquidity problems.

But these are simply my beliefs. In the editorial itself, there is no hint of a conflicted mind. Lucas clearly intends to leave the reader with the belief that monetary policy is an effective tool for combating the downturn. I would like to know if he has genuinely changed his mind on monetary policy, if he meant effective only in resolving liquidity crisis, or if he had some third agenda I failed to notice.

The editorial surprised me.


Note: If this crisis is merely a flight to quality, why have the Fed’s actions not resolved the crisis? The Fed has expanded its balance sheet by more than 10 percent of GDP. This action should have been more than sufficient to resolve any liquidity crisis. Remember, that when the Federal government prevents a run on the bank by becoming the lender of last resort, it never actually has to spend any money. The mere fact that it stands behind the bank should end the crisis.

I believe, as does Lucas, that the Fed is doing the best it can to end the crisis and that the zero bound itself is meaningless with respect to the conduct of monetary policy. I also believe that the Fed is the institution best situated to deal with financial crises. It can move quickly and its movements create a minimum of market distortions. I do not, however, share his belief that mere loans from the central bank can resolve the crisis.