Lucas on Monetary and Fiscal Policy

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The most productive way to read Robert Lucas is to take him very seriously. What follows does just that with respect to the his examination, in the early 1980s, of the proper design of monetary and fiscal policy. Lucas summarized his ambitions and conclusions in the 1984 Harvard University Political Economy Lecture, which is reprinted in his Collected Papers on Monetary Theory (2013, p.193): “My objective in this lecture will be to spell out in a unified way all of the neoclassical welfare-economic principles that bear on the efficient conduct of national, or aggregative, monetary and fiscal policy.”

Lucas systematically works through the implications of market-centric continuous general-equilibrium modeling and is not shy about the results. That modus operandi has been his great value-added to the profession. If some readers find his implications unacceptable, and many do, they had better be equally careful in figuring out what it is about mainstream theory that causes it to yield erroneous conclusions. Here’s a hint to unreconstructed Keynesians: It is not rational expectations.

After working through static, dynamic, and time-consistent permutations of mainstream neoclassical thinking, he concludes that efficient macro policy must be constructed on two “constitutional” rules of the game imposed on all governments: “That capital levies – taxes on previously accumulated capital and their equivalents – be set at zero, and that monetary policy be pre-committed to the maintenance of a specific path of nominal prices. Under these rules, [efficient Ramsey taxes] are time-consistent. It is this tax structure, together with the debt policy that enforces its time-consistency, together with these two essential monetary and fiscal pre-commitments, that I now want to call an efficient policy…. Moreover, the policy can be implemented by governments with no power to set tax rates for their successors provided, and only provided, that no government can resort to capital levies and none has any discretionary authority over monetary policy.” (p.207)

The GEM Project demonstrates that, Lucas’s stabilization conclusions are simply wrong. In the modern context of highly specialized economies, they are not consistent with coherent dynamic general-equilibrium analysis, returning us to the central question. What is it about mainstream theory that causes erroneous policy advice? The problem is not the most famous Lucas innovation, rational expectations. (If defined as the efficient acquisition and use of relevant information, how can it be?) Nor is it representative households or competitive markets. The consensus model-building mistake results from ignoring fundamental changes in the global production landscape occurring in the past century and a half, producing a problem that is much simpler and more powerful than the usual suspects. Lucas’s failure to be stabilization-policy relevant is rooted in the non-intuitive restriction of rational price-mediated exchange to the marketplace.

By generalizing optimal exchange to the large-establishment workplace, the GEM Project has been able to derive meaningful wage rigidity (MWR), capable of suppressing rational labor-price recontracting, from axiomatic model primitives in the context of continuous, general decision-rule equilibrium. The Project easily demonstrates what macro theorists used to know. Optimizing MWR is a game-changer. In highly-specialized economies, MWR uniquely microfounds causation from adverse nominal demand disturbances to involuntary job loss. That result turns Lucas’s market-centric policy conclusions upside-down. The most effective management of costly macro externalities rooted in fluctuating total nominal spending requires discretionary stabilization-authority intervention in aggregate nominal demand. Given MWR and its associated nominal rigidities, policymakers cannot rely on behavior of price-inflation to be a timely, accurate indicator of employment/output instability. They must, instead, directly analyze and target real-side behavior. Why is it so difficult today to accept what used to be mainstream gospel, i.e., that pre-commitment to price stability has a necessary companion in pre-commitment to full employment?

The mystery of money is much more consequential than Lucas, guided by outmoded market-centric thinking, has yet been able to grasp: “The model does not deal with business cycles…. I am persuaded by the evidence Friedman and others have marshaled that associates at least major recessions with monetary instability, so that I believe a monetary policy selected on the efficiency grounds I have discussed would, as a kind of by-product, be an adequate counter-recession policy.” (p.209) The GEM Project easily makes the counter-case that policy-relevant macroeconomics must deal with aggregate instability rooted in aggregate nominal demand.

I believe that one of the greatest costs of mainstream market-centric thinking has been confining the attention of able theorists to second-tier problems. Time-consistency is small potatoes compared to agreeing on how to manage to halt and reverse the sort of total-spending contraction that began in the second half of 2008. Who doesn’t agree that Ricardian equivalence does not apply in circumstances of huge inefficiencies associated with large-scale cyclical market failure?

My guess is that Lucas has always been suspicious, deep-down, that something is amiss with his macro-policy principles. Nonetheless, he jumps to the reckless conclusion that we must work with the model we have: “It may be that some day we will have an operational theory of business cycles that suggests additional, useful principles besides those I have discussed. In the meantime, it seems sensible to me to take policy guidance from models we can actually understand and work through, not from models we wish we had, or models other people think we have.” (p.209) He glosses over that waiting for the better model, which I believe to be the generalized-exchange theory, has produced a corrosive period of macroeconomists pushing inaccurate, damaging advice on stabilization policymakers. Moreover, what is to de done about the ossification of consensus thinking, rooted in the huge accumulation of human capital that must be depreciated once better model emerges?  Mainstream gatekeepers in the academy clearly have experienced dulled alertness to the “some day” possibility of an operational business-cycle theory that actually supports effective stabilization policymaking. Badly narrowed awareness combined with self-interest in impeding any replacement of market centricity erects substantial mainstream barriers to someday better models.

Blog Type: Wonkish Saint Joseph, Michigan


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