Robert E. Lucas: money really exists!
from Merijn Knibbe
Robert E. Lucas is discredited with being one of the most influential neo-classical economists of the past decades. His work is characterized by a rather complacent tone and a clear denial of the Real World. Did the crisis change him? Yes, and no. Together with Nancy Stokey he published a paper about the crisis. What changed?
Close reading shows that Lucas is as complacent as ever. A quote:
“Another example is the unexpected fall in house prices in 2007–08, which led to a reduction in construction activity“
Ahem. What he of course means is “the fall in house prices which was unexpected to me (and Greenspan and indeed many other economists)”. The regular reader of this blog will however know that the fall was not unexpected to Dean Baker and, even more so, to Fred Foldvary and Mason McGaffney (real estate bubbles are a kind of Georgist specialty). Foldvary and McGaffney were spot on with this one. And not just with the prediction – also with theory behind it (including predictions of increasing financial fraud and the like). And the Shiller house prices graph is of course rightly famous. In 2005 at the latest it was clear to every observer that the price increase utterly unsustainable. From 1994 on there had been a linear increase in the rate of increase of prices in a situation of more or less stable inflation, after 2003 the increase of the rate of increase even became exponential for a predictable short time - the classic unsustainable positive feedback bubble situation: http://www.homes360.info/hows-the-market/tracking-home-prices-latest-case-shiller-report-2/) . There are some flimsy excuses why the existing of a housing bubble was unexpected to Lucas, in 2005. In 2006 however, the rate of increase of prices was falling at a dramatic rate - there were not even flimsy excuses anymore. Writing in 2011 that nobody expected it is wiping your own sheet clean. Bad, complacent science.
However, the worldview of Real Business Cycle man seems to have changed, a little. Money exists and does matter: “These crises are situations in which individuals and firms want to build up their holdings of liquid assets, cash and other securities that are close to cash in the sense that they can be exchanged for cash easily and at a predictable price. These assets have a special role because they are used, indeed required, for carrying out transactions.”
Ahem. This is equal to: “People use money to pay and depending on the circumstances they like to have more or less money”. Big deal? Yes, Big Deal as the Lucas style world of optimization is, essentially, a barter economy (see below). But now he concedes that money exists, that there is a reason why we spend so much money and resources on banks (4 to 8% of GDP!) and insurance companies and cash registers and cash holdings, that foresight is not perfect and whatever. …. What Lucas in fact does is leaving the “MaxU from here to eternity perfect foresight neo classical barter optimization economy”. He introduces money in the model – and the logical consequence is a world of liquidity crises and, by implication, even liquidity traps and instability in which the Ben Bernanke’s of this world are forced to increase bank reserves from 40 billion to 800 billion in three months. Once, Lucas will be a post-Keynesian… There is of course nothing new here, as the regular reader of the Brad de Long blog will know (Brad again and again points out that John Stuart Mill already identified the effect described by Lucas and Stokey in the twenties – of the nineteenth century). The whole thing about Real Business Cycle theory was of course to deny that money and liquidity crises and traps credit induced bubbles and busts and involuntary unemployment existed… Guess what – they’re baaaaack (to paraphrase Krugman).
Maybe you think I’m overstating my ‘neo-classical barter economy case’. I’m not. There is a reason why Lucas and Stokey introduce money – they use a mainstream neo classical model of bank runs. And this model does not include money. A model of bank runs which does not include money? Yes. Unbelievable? Yes. But true. According to Lucas and Stokey, ”A simple and widely used theoretical model of bank runs was developed by Douglas Diamond and Philip Dybvig (1983). It describes an economy in terms of the production and consumption of a real good, but to apply their model to actual banking practice, it is helpful to give it a monetary interpretation“. Help.
Lucas and Stokey however still seem to be in some kind of shock. As if it’s a new insight, they write: “The events that followed the failure of Lehman Brothers in September of 2008 were not a modest recession”. No, they weren’t. The whole paper is by the way little more than a summary of rather familiar insights – that is, familiar to non neo-classicals, it seems.