Over at Econlog I have a new post discussing the legacy of my favorite economist—Milton Friedman. Here I’d like to discuss how my view of macro has been shaped by Robert Lucas and Eugene Fama, two other famous Chicago economists. In some ways these are odd choices. I focus on demand-side models of the business circle, and Fama seems to think AD doesn’t matter. And I never even took a class from Fama. I did take several classes from Lucas, and he was my PhD advisor. But I never really bought into his “microfoundations” approach to macro. My “musical chairs” model of unemployment is about as far from Lucas as you can get. He’d be horrified. But great ideas can show up in all sorts of surprising and unexpected places. And even though I think that Lucas and Fama overestimate the flexibility of labor markets, I believe they are right on the mark in some other important areas. Here’s what I learned from Lucas:
1. The long run is now: I used to have a lazy belief that the term “in the long run” meant something like “in the future,” and short run meant the present, or very near future. Lucas taught me that the long run is (also) right now. The term ‘long run’ refers to situations where factor X effects factor Y with a long delay. It has nothing to do with present and future. And yet I often hear even professional economists talk as if the term “in the long run” meant in the future.
Here’s one example. The short run effect of monetary policy is called the liquidity effect. A change in the money supply causes interest rates to move in the opposite direction, in the short run. The long run effects of monetary policy are called the income effect, the price level effect and the expected inflation (Fisher) effect. These three effects all cause interest rates to move in the same direction as the money supply. If you erroneously thought that “short run” meant “now” you would interpret any current change in interest rates through the lens of the liquidity effect. That is, you’d assume falling interest rates reflect an easier monetary policy, and vice versa. Lucas taught me that what’s going on right now is equally likely to be the long run effect of policies that happened earlier. Thus falling interest rates might just as well be the long run effect of an earlier tight money policy. How can you tell which is which? Ben Bernanke says you look at NGDP growth and inflation. And what happened to those two indicators in 2008-09?
2. Think regimes, not discretionary policy choices: It’s tempting to debate monetary policy without reference to a policy regime. People debate “what should the Fed do now,” as if the question makes sense in the absence of a clear policy framework. Now in fairness there are some policies that are so obviously bad, under such a wide range of plausible policy regimes, that it’s tempting to just come out and say “money is too tight” (i.e. 1931) or “money is too easy (i.e. 1979). But in most cases the discussion pits one plausible policy against another, with no agreed upon destination. Unfortunately people play lip service to the need for clear policy rules, but in practice they don’t buy into this approach because they don’t trust policymakers to have the right policy rule. Thus the Fed minutes show a confusing debate over how best to get to the right destination, among policymakers who don’t even agree on the correct destination.
And people may have good reason for not trusting the policymakers to adopt the correct rule, look at the BOJ in the 1993-2012 period, and the ECB in recent years, both clearly aiming at the wrong policy target.
3. Rational expectations: It makes no sense to have a model of the economy that assumes X, but which is filled with people who believe “not X.” As Bennett McCallum pointed out this idea is better called “consistent expectations,” as the term “rational” has all sorts of connotations that have nothing to do with the public’s expectations being consistent with the model of the public’s behavior. Rational expectations also underlies the “Lucas Critique,” the idea that a statistical relationship that is true under one policy regime, may not hold up if the policy regime is altered to take advantage of that statistical relationship.
4. The “voluntarily unemployed” might still be miserable: If someone loses a job as an accountant and turns down an open position at McDonalds, they might be considered “voluntarily unemployed.” That makes me agree with Lucas that the term is pretty much useless. I’d add that I don’t find either side of the “deserving/undeserving poor” debate to be making useful arguments, for similar reasons. I focus on how policy affects outcomes, and leave to God the question of who is or isn’t deserving of more out of life.
Fama is famous for the efficient market hypothesis, which underlies several important pieces of market monetarism, or at least my peculiar version of MM:
1. No wait and see: When a new policy initiative aimed at boosting AD is announced, it makes no sense to “wait and see” if it will work. The market reaction immediately tells us the expected impact of the policy, and anything different that occurs will reflect unexpected shocks that violate the “ceteris paribus” assumption. If the Fed was expected to cut rates by either a 1/4% or 1/2%, and the fed funds futures market assigns probabilities to each outcome, then the actual response of TIPS spreads and stock prices to the policy announcement tells us almost all we will ever learn about the policy. If we had a NGDP futures market we could even do better, but the markets we do have give us a pretty good idea of the impact of unexpected policy announcements.
2. Target the futures price of the policy goal: It’s silly to have intermediate targets such as the fed funds rate, or the exchange rate. Simply adjust the monetary base as necessary to keep the futures price of the policy goal variable on target. But of course first you need to create a futures market for the policy goal variable (preferably NGDP.)
3. Bubbles? No such thing: Or more precisely the bubble theory is completely vacuous–it doesn’t help us to better understand the world around us. When house prices soared in the early 2000s in Canada, the US, Australia, New Zealand and Britain, people cried bubble. That did not help me to understand why in Australia they later soared even higher, in the US they plunged lower, and in the other three they mostly moved sideways. When Bitcoin soared from $1 to $30, people cried bubble. That told me nothing useful about why prices later rose to $1000 and then fell to $600. When Robert Shiller said stocks were a bubble in 1996, it told me nothing useful about the future path of stock prices. And I could go on and on.
4. Ignore the financial system: I know what you are thinking. ”Wait a minute—surely Fama never said to ignore the financial system, that’s what he spent his whole life studying.” But he did understand that money (MOA) and credit are completely different entities. He suggested that the Fed could stabilize the price level (and by implication NGDP) simply by controlling the currency stock. In a sense he was talking about control of the monetary base, but in those days the base was almost entirely currency and required reserves, and he thought reserve requirements were a silly regulatory policy that could be dispensed with. So control of the stock of currency was all you need in order to control the value of currency. And since the value of currency is (by definition) the inverse of the price level, that’s all you needed to control the price level, or any other nominal aggregate. Monetary theory without banking and finance—the 2008 financial crisis shows us how important it is to divorce these concepts. Economists who see them as being linked got 2008 all wrong. They thought the real problem was banking distress, when in fact the real problem was nominal (GDP.)
MMTers should not read Fama’s currency paper; it would give them a heart attack.