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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  1. Mott groom May 5, 2016

    From the economist.
    Are you sure your models are reflecting today,s economies?
    How to measure prosperity

    GDP is a bad gauge of material well-being. Time for a fresh approach

    WHICH would you prefer to be: a medieval monarch or a modern office-worker? The king has armies of servants. He wears the finest silks and eats the richest foods. But he is also a martyr to toothache. He is prone to fatal infections. It takes him a week by carriage to travel between palaces. And he is tired of listening to the same jesters. Life as a 21st-century office drone looks more appealing once you think about modern dentistry, antibiotics, air travel, smartphones and YouTube.
    The question is more than just a parlour game. It shows how tricky it is to compare living standards over time. Yet such comparisons are not just routinely made, but rely heavily on a single metric: gross domestic product (GDP). This one number has become shorthand for material well-being, even though it is a deeply flawed gauge of prosperity, and getting worse all the time. That may in turn be distorting levels of anxiety in the rich world about everything from stagnant incomes to disappointing productivity growth.
    Faulty speedometer
    Defenders of GDP say that the statistic is not designed to do what is now asked of it. A creature of the 1930s slump and the exigencies of war in the 1940s, its original purpose was to measure the economy’s capacity to produce. Since then, GDP has become a lodestar for policies to set taxes, fix unemployment and manage inflation.
    Yet it is often wildly inaccurate: Nigeria’s GDP was bumped up by 89% in 2014, after number-crunchers adjusted their methods. Guesswork prevails: the size of the paid-sex market in Britain is assumed to expand in line with the male population; charges at lap-dancing clubs are a proxy for prices. Revisions are common, and in big, rich countries, bar America, tend to be upwards. Since less attention is paid to revised figures, this adds to an often exaggerated impression that America is doing far better than Europe. It also means that policymakers take decisions based on faulty data.
    If GDP is failing on its own terms, as a measurement of the value-added in an economy, its use as a welfare benchmark is even more dubious. That has always been so: the benefits of sanitation, better health care and the comforts of heating or air-conditioning meant that GDP growth almost certainly understated the true advance in living standards in the decades after the second world war. But at least the direction of travel was the same. GDP grew rapidly; so did quality of life. Now GDP is still growing (albeit more slowly), but living standards are thought to be stuck. Part of the problem is widening inequality: median household income in America, adjusted for inflation, has barely budged for 25 years. But increasingly, too, the things that people hold dear are not being captured by the main yardstick of value.
    With a few exceptions, such as computers, what is produced and consumed is assumed to be of constant quality. That assumption worked well enough in an era of mass-produced, standardised goods. It is less reliable when a growing share of the economy consists of services. Firms compete for custom on the quality of output and how tailored it is to individual tastes. If restaurants serve fewer but more expensive meals, it pushes up inflation and lowers GDP, even if this reflects changes, such as fresher ingredients or fewer tables, that customers want. The services to consumers provided by Google and Facebook are free, so are excluded from GDP. When paid-for goods, such as maps and music recordings, become free digital services they too drop out of GDP. The convenience of online shopping and banking is a boon to consumers. But if it means less investment in buildings, it detracts from GDP.
    Stop counting, start grading
    Measuring prosperity better requires three changes. The easiest is to improve GDP as a gauge of production. Junking it altogether is no answer: GDP’s enduring appeal is that it offers, or seems to, a summary statistic that tells people how well an economy is doing. Instead, statisticians should improve how GDP data are collected and presented. To minimise revisions, they should rely more on tax records, internet searches and other troves of contemporaneous statistics, such as credit-card transactions, than on the standard surveys of businesses or consumers. Private firms are already showing the way—scraping vast quantities of prices from e-commerce sites to produce improved inflation data, for example.
    Second, services-dominated rich countries should start to pioneer a new, broader annual measure, that would aim to capture production and living standards more accurately. This new metric—call it GDP-plus—would begin with a long-overdue conceptual change: the inclusion in GDP of unpaid work in the home, such as caring for relatives. GDP-plus would also measure changes in the quality of services by, for instance, recognising increased longevity in estimates of health care’s output. It would also take greater account of the benefits of brand-new products and of increased choice. And, ideally, it would be sliced up to reflect the actual spending patterns of people at the top, middle and bottom of the earnings scale: poorer people tend to spend more on goods than on Harvard tuition fees.
    Although a big improvement on today’s measure, GDP-plus would still be an assessment of the flow of income. To provide a cross-check on a country’s prosperity, a third gauge would take stock, each decade, of its wealth. This balance-sheet would include government assets such as roads and parks as well as private wealth. Intangible capital—skills, brands, designs, scientific ideas and online networks—would all be valued. The ledger should also account for the depletion of capital: the wear-and-tear of machinery, the deterioration of roads and public spaces, and damage to the environment.
    Building these benchmarks will demand a revolution in national statistical agencies as bold as the one that created GDP in the first place. Even then, since so much of what people value is a matter of judgment, no reckoning can be perfect. But the current measurement of prosperity is riddled with errors and omissions. Better to embrace a new approach than to ignore the progress that pervades modern life.
    Copyright © The Economist Newspaper Limited 2016. All rights reserved. This article is for your personal, non-commercial use. You may not modify, reproduce, transmit or commercially exploit it. Visit for more global news, views, and analysis from The Economist.