Robert Lucas says to relax, everything will be just fine if we maintain a commitment to low unwavering taxes and strict inflation targeting:
Mortgages and Monetary Policy, by Robert E. Lucas, Jr., Commentary, WSJ: In the past 50 years, there have been two macroeconomic policy changes ... that have really mattered. One of these was the supply-side reduction in marginal tax rates... The other was the advent of "inflation targeting," ... monetary policy focused on inflation-control to the exclusion of other objectives. As a result of these changes, steady GDP growth, low unemployment rates and low inflation rates ... have been a reality in the U.S. for more than 20 years.
Both of these reforms work, in part, because they stabilize people's expectations about aspects of the future. The supply side tax cuts, in contrast to Keynesian on-again-off-again temporary tax cuts, are designed to be in place over the long run... Inflation targeting is a commitment that no matter what unpredictable shocks the economy is subjected to, the Fed will do what is needed to restore a fixed, target inflation rate and so maintain a "nominal anchor" to expectations.
This summer's subprime mortgage crisis puts the long-run emphasis of inflation targeting to a severe test. Something has to be done right now. What should it be? There are two distinct aspects to this test, which deserve separate analysis.
There is an immediate risk of a payments crisis, a modern analogue to an old-fashioned bank run ... that ... can force otherwise solid enterprises into failure. ... There is no way to rule this possibility out based on market forces alone: If everyone else wants to cash out, then I want to be first in line. So we need a second commitment by the Fed, unrelated to inflation control, to ... serve as lender of last resort.
By reducing the discount rate and encouraging use of the discount window -- instead of reducing the funds rate until yesterday -- I think Mr. Bernanke was trying to separate the short-term problem of lender of last resort and the long-term problem of inflation targeting, and to show that we can and will deal forcefully with the liquidity crisis, if one should emerge, without weakening the commitment to price stability.
The need for a lender-of-last-resort function is one qualification to the discipline of inflation targeting, but it is a necessary one. There is a second line of argument that seems to me much less compelling.
It ... is all too easy for easy money advocates to see a recession coming and rationalize low interest rates. ... [But] I am skeptical about the argument that the subprime mortgage problem will contaminate the whole mortgage market, that housing construction will come to a halt, and that the economy will slip into a recession. Every step in this chain is questionable and none has been quantified. If we have learned anything from the past 20 years it is that there is a lot of stability built into the real economy.
To me, inflation targeting at its best is an application of Milton Friedman's maxim that "inflation is always and everywhere a monetary phenomenon," and its corollary that monetary policy should concentrate on the one thing it can do well -- control inflation. It can be hard to keep this in mind in financially chaotic times, but I think it is worth a try.
Update: See Brad Delong.