Lucas: Monetary Policy Can Still be Effective

Robert Lucas says monetary policy can still effectively stimulate new spending even though the target interest rate is already at or near zero, and that monetary policy is preferable to fiscal policy:

Bernanke Is the Best Stimulus, by Robert E. Lucas Jr., Commentary, WSJ: The Federal Reserve’s lowering of interest rates last Tuesday was … received with skepticism. Once the federal-funds rate is reduced to zero, or near 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 should be no mystery about what he has in mind. Over the past four months the Fed has put more than $600 billion of new reserves into the private sector… This action has been the boldest exercise of the Fed’s lender-of-last-resort function in the history of the Federal Reserve System. Mr. Bernanke said that he is prepared to continue … this discounting activity as long as the situation dictates.

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 not 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.

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, in my opinion, and it will continue to have many advantages in future months. 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. The cash comes in the form of loans. It entails no new government enterprises, no government equity positions in private enterprises, no price fixing or other controls on the operation of individual businesses, and no government role in the allocation of capital across different activities. These seem to me important virtues.

There’s a reason they used to be called “monetarists”. If we wait to see if monetary policy does, in fact, work as advertised and we find out that it doesn’t, it will be too late to implement effective fiscal policy. So yes, by all means use monetary policy to the best of our ability, but let’s not forget about fiscal policy. If monetary policy is as fast and flexible as claimed, then it can always be reversed in the event that fiscal policy kicks in with more force than expected.

As to the argument that fiscal policy distorts the allocation of capital, that doesn’t necessarily happen. As I’ve argued in the past:

One reason I am not as concerned with the efficiency aspect as others is that I believe there are a lot of public goods – goods the private sector won’t invest in on its own due to market failures – that we need to repair or put into place that are crucial to our long-run growth potential. Cutting taxes won’t bring these goods about… For this reason, I don’t think government spending [necessarily] loses to tax cuts on … the efficiency … margin…

And as Paul Krugman argued yesterday:

Bad anti-stimulus arguments: A number of conservative economists have been arguing against a stimulus plan centered on government spending. Fair enough. But one argument I keep reading bugs me: it’s the claim that spending-based stimulus is bad because economic theory tells us that a marginal dollar of private spending is better than a marginal dollar of government spending.

That’s just wrong… Yes, the standard theory of consumer choice says that a consumer gains more utility if he or she gets to freely allocate a dollar of spending than if someone else makes the choices: I’d rather buy myself a $10 meal than have you feed me $10 worth of food that you select.

But that’s not what we’re talking about when we talk about stimulus spending: we’re not talking about the government buying consumption goods for the public at large. Instead, we’re talking about spending more on public goods: goods that the private market won’t supply, or at any rate won’t supply in sufficient quantities. things like roads, communication networks, sewage systems, and so on. And every Econ 101 textbook explains that the provision of public goods is a necessary function of government.

When we’re asking whether it’s better to have the government stimulate the economy or to try to stimulate private spending, we’re asking among other things whether a marginal dollar spent on public goods is worth more or less than a marginal dollar spent on private consumption. And there’s nothing, even in Econ 101, that clearly favors private spending on private goods over public spending on public goods. …

The misallocation point is not central to Lucas’ argument about why fiscal policy is inferior to monetary policy, but it is part of it. Among conservatives who do believe fiscal policy is needed, however, the misallocation argument is a central part of their insistence that tax cuts dominate government spending as a fiscal stimulus measure. But, again, this ignores the public goods aspect of the spending.

Originally published at the Economist’s View reproduced here with the author’s permission.