Robert Lucas: Mortgages and Monetary Policy

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.

Comments

[Cyrille]

I find it hard to take seriously an article that pretty much begins with stating that supply-side tax cuts work wonderfully well.

I know he has FAR more economic credibility than I could ever dream of, I know...

Still...

Having said that, I'd be all for a commitment to an inflation target. I got the impression, though, that the Fed had other objectives as well (unlike the ECB).

But I do think that there is a significant risk of contagion, not of the subprime crisis, but of the real estate one. It was a worldwide bubble after all! Consumption has been so driven by debt in the States that something must give. Either you inflate away, and there goes the commitment, or consumption must plumet at some stage.

Which is why a commitment to low inflation and much higher taxes (it's not like there wouldn't be plenty to do with them), especially on the wealthy, would be the right policy.

I completely fail to see what good the commitment to ridiculously low taxes on the filthy rich is doing any good at all -especially once you admit that unredistributed GDP is a very poor target for a nation.

[reason]

The past is not necessarily a good guide to the future. I'm inclined to agree that very high marginal rates are not a good thing (but I mean VERY high) particularly when they affect the poor or middle class and that observed stability has improved as a result of monetary targeting. How much of this is due to monetary targeting and how much due to globalisation and other structural changes is not however clear to me.

What he does not comment on, however is financial sector institutional change which looks increasingly disfunctional to me. What happened with non-prime mortgage lending is distressing - something is rotten in the financial system. Financial institutions shouldn't just be oblivious to risk (could it be they think they will privatise the profits and pass the costs on to the public?) This may in fact be a consequence of monetary restraint, evolution of institutions may well eventually find its way around any static control mechanism. The financial statistics we have been seeing (say on PRUDENT BEAR) paint a picture of a sleepily well behaved real statistics hiding a very dangerous financial environment. Surely he must be aware of Japanese economic history?

[bakho]

The top rates when Reagan took office may have been too high. However, top rates were not too high under Clinton. The economy under Clinton was better than it is today with the lower top tax rates. The Bush tax cuts are NOT sustainable and produce too little revenue. The top rate needs to return to 39%. Inflation is more easily targeted if their is fiscal balance. We are paying out over $200 Billion per year in interest on debt. $200 Billion is a lot of tax dollars (over 20% of individual income taxes).

The essay overlooks that we have been living off of past infrastructure investments. Our current infrastructure is deteriorating and we are underinvesting. That bill is starting to come due.

[paine]

what a bag of wind

the fact remains
nominal anchorage of what ???

dot stocks ???

residential lot prices ???

crude oil ???

wheat ???

nope

wages

result ????

well ... need i review
the path of wage rates
and wage share
post der volcker dammerrung ????

[Gerard MacDonell]

I am not a regulatory guy, just a lowly up and down economist. But I wonder if part of the problem with the agencies is not that THEY are unregulated but that their clients ARE regulated. A lot of assets are mindlessly purchased on the basis of the agencies' ratings because the law basically requires it. That law encourages the suspension of disbelief and perhaps should be relaxed, thereby making the ratings agencies less important. Everybody in the markets knows that the agencies are a joke, but we also know that large institutions follow their ratings as a matter of course. We might want to change that, rather than trying to fix the agencies themselves. They are probably incorrigible and the last thing we would want is to have them politicized. State-sponsored corruption is bad enough. State-run would be worse. None of this is meant to imply an endorsement of naked capitalism. I am liberal and making a technical point, I think.

[anne]

"It ... is all too easy for easy money advocates to see a recession coming and rationalize low interest rates."

"It ... is all too easy for tight money advocates to see an inflation coming and rationalize high interest rates."

The concern of such Republicans is always inflation at the expense of growth and employment and middle class well-being. However, thanks to Democrats the Federal Reserve has a dual mandate of fostering growth and limiting inflation.

[baileyman]

I fail to see why it should be true that reducing marginal rates should stabilize expectations.

[ken melvin]

If not directly, indirectly, these are times of wealth transfer be it from equity, pension funds, or infrastructure neglect. If they know, they don't care, so it be greed.

[paine]

gm

the civil courts require
a standard of fiduciary behaviour
the reg outfits become the systemic alibi

if as in many cases foreseeable
private profits proceed public loses
one needs a high flown legal looper
ie
alibi for continuing the scam

when viewed
at the proper level of generalization
nothing novel about any of this

btw

nice run of comments here

full of insight
and
in this case
insights bitter after taste

[paine]

b man

the savage simplicity
of
for all time
marg rate cuts

vs
the up down up
of tax rates
--as samuelson type macro managers
fine tune effective demand -----

kool hand lucas
assigns this discretionary
secondary uncertainty
ie
what will my tax on this be ???
to keynesian fiscal policy

of course
whats cut
"once and for all "
can be reapplied
"once and for all " too

as with the pending curtain drop
on the bush cuts
circa 10-12

[paine]

reason ...nice comment
once i wiggled thru its syntax

[Bruce Wilder]

cyrille: "I find it hard to take seriously an article that pretty much begins with stating that supply-side tax cuts work wonderfully well.

"I know he has FAR more economic credibility than I could ever dream of, I know..."

Please. The man is a reactionary and a liar. Let that be his reputation.

[paine]

bak

"Inflation is more easily targeted if their is fiscal balance. "

dangerous assumption
often leads as it has in the last 30 years
to a profound anti fiscal tilt
in macro efffective demand management

really a two stage process

first fiscal macro tilts toward fine tuning tax cuts
and away from
counter cyclical gub expenditures
circa 46-64

then on to

monetary manip of household expenditures thru
rate moves

84-00

[paine]

bw
"The man is a reactionary and a liar"

indeed indeed indeed

the oliver north of macro

[calmo]

Such a slap painewhat a bag of windAnd if Lucas were here, I'd hit him over the head with a cold slimy fish...but just about any of these comments stuffed into his ear with a pool cue would do.
Does this In the past 50 years, there have been two macroeconomic policy changes ... that have really mattered. sound like a receptive ear, (hot in the pursuit of truth), to you ...or a sphincter gone awry, (confident, blind and laughable --as the dispenser of truth)?
Lucas encourages us to slap back thinking his Nobel "really matters" (off your knees people!) and we won't hit him that hard...but all the more reason to wake this pompous ass up...imevasoHO.

[johnchx]

Robert Lucas writes:In the past 50 years, there have been two macroeconomic policy changes in the United States that have really mattered. One of these was the supply-side reduction in marginal tax rates, initiated after Ronald Reagan was elected president in 1980 and continued and extended during the current administration.
...
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...

And Milton Friedman says, "To spend is to tax."

Which means that the supply-side tax cuts are exactly the opposite of "designed to be in place over the long run." Instead, they guarantee an unknowable mix of tax increases and spending cuts at an unknowable point in the future. They are profoundly destabilizing of expectations.

It's a pity. Robert Lucas was a very smart guy, once.

[paine]

commenting at top speed

"It ... is all too easy for easy money advocates to see a recession coming and rationalize low interest rates."

"It ... is all too easy for tight money advocates to see an inflation coming and rationalize high interest rates."

anne anne anne

"I wonder if part of the problem with the agencies is not that THEY are unregulated but that their clients ARE regulated"

gm

"sleepily well behaved real statistics hiding a very dangerous financial environment"

reason

[paine]

uncle milty
master of the wall street koans

"To spend is to tax "
and
"to tax is to spend "

then again to tax is to scotch spending too eh
your spending is stopped and uncle spending increased ??
and o spending a tax is taxing away a spending to spend a taxing

really uncle milt wants the trans nat incers to spend not uncle sam
least of all---- and here comes the ws koan's back drop----

least of all
spending the proceeds of monetized t bonds
ie
that kold war side kick
"the inflation tax"

anothe bowl
of pure bobo-nomics
for mr john q "i like ike " babbit

[ken]

Tax cuts lead to lower revenue. But because tax cuts have always been matched with substantial increases in deficit spending the economy grows. And growing the economy through growing borrowing leads to higher goverment revenue.

It is the deficit spending that is stimulative. Taxes have had nothing to do with it.

Anyone who thinks otherwise is an idiot, a conservative extremist, or both.

[paine]

"Robert Lucas was a very smart guy, once"

he still is

you're not writing op eds for the ws journal are u ???
i know i'm not

smart moves to where smart gets rewarded

i suspect

lucas the academe pre fame
was a sharp mountain of madness high minded
"free thinker " in a context of liberal stampede
but now after years in the bright lights ....
he's morphed into just another shrewd homo benthamo

in search of a big down to earth
personal utility kick

eight parts fame to one part fortune

[paine]

"It is the deficit spending that is stimulative"

indeed in an endemically demand constrained system

the marginal spender is a god sent

by preference

let uncle spend
on our people's credit card

not distribute the spending
to us tight wage rate strapped householders
thru looser usury standards
and ponzi lot values

Uncle S can make mr big pay
our people's credit card debt service

we the sheeeple can't
get anyone to pay our personal household debts
we gotta hire out more of our time and effort
to ...the man
if we're to stay afloat

[kthomas]

Gerard MacDonell, that was a very insightful observation. I would favor such a move. How interesting THAT would be....no ratings agencies. It has some validity.

Don't you go talking about ridding our markets of auditors now!

says...

Happy Birthday Bob!

[Andres V]

It's amazing just how much denial there is about the severity of the housing downturn. Housing starts have dropped nearly 40% over two years, we're seeing nearly unprecedented falls in house prices and core PCE inflation is below 2%. Why are there still people who question the need for rate cuts?

Just more proof that winning a Nobel prize doens't guarantee having common economic sense.

[wjd123]

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...R.E. Lucas,Jr.

Wait a minute. Is it the tax cut or the stability of people's expectations about aspects of the future which counts. If it's stability of expectations which counts toward economic growth we could have guaranteed the rich tax rates at 90% and gotten the economic growth we wanted.

Since Reagan the rich have had three tax rate cuts and one increase during the Clinton Administration. Shouldn't the economy have tanked during the Clinton Administration because the expectations of the rich were shaken. It didn't happen, in fact, the economy grew.

[johnchx]

wjd123 wrote:Since Reagan the rich have had three tax rate cuts and one increase during the Clinton Administration. Shouldn't the economy have tanked during the Clinton Administration because the expectations of the rich were shaken. It didn't happen, in fact, the economy grew.

Interesting. Actually, the argument works in the opposite direction. During the Clinton Administration, revenues began to come close to matching the Federal governments expenditures, which meant that current spending wasn't creating imponderable future tax liabilities (i.e. tax liabilities of unknown incidence and timing). In 1999, for the first time in ages, we actually knew who was paying how much to support the Federal government.

So expectations were actually much firmer during the later Clinton years than during big-deficit regimes before and after.

[Thomas T. Schweitzer]

Frankly, I cannot undestand Lucas. In the 19th century the industrialized countries had the gold standard, which was as good a guarantor of inflation expectations as any, and they had low taxes. Nevertheless the economy was, if at all, less stable than since WW2. Does one become a laissez faire fundamentalist and become divorced of realism once one starts writing for the WSJ? I think neither Lucas, nor anybody else knows how expectations are formed, and when and how they change.

[Lafayette]

RL: 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.

Should read: "As a result of these changes, steady GDP growth, low unemployment rates and low inflation rates but high income inequality ... have been a reality in the U.S. for more than 20 years."

Selective reasoning should not impress anyone ... except the already convinced.

[esb]

http://www.billcara.com/ztp002.jpg

[esb]

The immediately-above link has made it to the desk of just about every trader/money runner/hedge fund manager in the entire world.

BB has morphed overnight into an object of derision.

This sort of reminds me of the great line in "The American President," "The time it takes to go from being a pit bull to a prom queen can be measured with an egg timer."

[paine]

TTS

"the (gold standard ) economy was ....
less stable than (the two successive fiat systems ) since WW2 "

rule number one

when talking about
the economic system's
endogenous laws of motion
never look back
beyond the last 25 years
u might expose the thread bare farce
we must endure
with all this "high policy" rationalizing

[Thomas T. Schweitzer]

paine

with all due respect, I have doubts about your rule number one: "when talking about the economic system's endogenous laws of motion, never look back beyond the last 25 years". There is reasonable agreement among economists that expectation formation does matter. While of course the world has changed tremendously during the last 25 years (and so it has every 25 years, at least since 1750), I suspect the way human beings form expectations has changed much less. Nevertheless, we don't know anything about this way, and how it applies to the present environment. And I doubt Lucas does, either.

[calmo]

Expectation formation...sounds like right out of the Chomsky playbook (but what do I know about communication?) [So you hear that? Or were you payin attention to something else that would make a Red Terror Alert infinitesimal...like that wasp that just went up your shorts.]
Ok, Thomas, I'm expectin Big Things from you now. Such a trashing of that anemic Existentialism (you might not have expected that, but twas) and promise of explication of "since 1750" (maybe more).
Expectation formation and maintenance...waiting for Thomas's reply, you?