Bob Lucas leads Chicago economics into a Keynesian free fall

“If you think Bernanke did a great job tossing out a trillion dollars, why is it a bad idea for the executive to toss out a trillion dollars?  It’s not an inappropriate thing in a recession to push money out there and trying to keep spending from falling too much, and we did that.” Robert E. Lucas, The Wall Street Journal, September 24, 2011

One would expect such fallacious remarks to emanate from  East Coast Nobel Prize winning economists  such as Paul Krugman and Joseph Stiglitz.  When the words pour out over the forked tongue of a Chicago, Freshwater economist like Bob Lucas, one knows that the disease has metastasized and is now spreading out of all control. 

We’re all Keynesians now’ crowed Richard Nixon in 1968, just at the moment when the profession was waking up to the Keynesian fallacy. Well, it turns out that Tricky Dick was focused on the long term, rather than the short, and that he had Nobel Prize winner Robert Lucas firmly in his sights.

There may be some residual hope for Chicago Economics. Lucas has now turned 74 and has moved into retirement, at least from undergraduate teaching. So the minds of the young will not be exposed to the economic mis-perceptions  that Helman W. Watkins Jr. met when he interviewed the Nobelist for his WSJ column. Unfortunately, there is yet another Benedict Arnold – in the form of Richard A. Posner  – still wandering the hallowed corridors of that once great program.  And it must be remembered that Barack Obama was allowed ten totally unproductive years in the Chicago Law School, learning from Judge and Senior Lecturer  Richard Posner, while awaiting his opportunity for a Liberal-Democrat bid for the  White House.

In any event, and for whatever reason, it turns out that Bob Lucas was an early advocate  for Obamanomics:

“I ask about a report that he voted for Barack Obama in 2008, supposedly only the second time he had voted for a Democrat for president.  ‘Yeah, I did.  My parents are dead for a long time, but my sister says, “You have to vote for Obama,for what it would have meant for Mom and Dad.’  I felt that too.  It’s a huge thing. This history of racism has been the worst blot on this country.  All of a sudden this charming, intelligent guy just blows it away. It was great.’ ” Holman W. Jenkins, Jr., ‘Chicago Economics on Trial’, The Wall Street Journal, September 24, 2011

Well, it was a momentous shift to the left for the United States. And President Obama really did help to blow the United States economy downwards  on its free fall into Second World status.  Just as Bob Lucas (and Richard Posner)  have done their level best respectively to blow Chicago Economics and Chicago Law downwards  from Freshwater to Saltwater status in one generation. 

 Let us hope and pray that Bob Lucas’s loss of focus is a monetary mis-perception that triggers just a real, Pareto-optimal economic cycle and not a permanent  prisoners’ dilemma  downshift in real economic performance.

If not, then there is a great deal of ruin in this particular Nobel Prize in Economics. And let us keep our fingers firmly crossed lest another Nobel Prize might be under consideration for the second Benedict Arnold on the Chicago faculty!  Or even, once Barack Obama is ejected from the White House, for the newly-returned Third Man.  After all it is the Swedish Academy that awards the Nobel Prize in Economics.

Paul Krugman on The Liquidity Trap

“We’re in a liquidity trap, with interest rates up against the zero bound.  This means that conventional monetary policy is’nt sufficient.”  Paul Krugman, The Conscience of a Liberal, November 13, 2009

“There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest.  But whilst this limiting case might become practically important in future, I know of no example of it hitherto (my italics).” John Maynard Keynes, The General Theory of Employment, Interest, and Money 1936

The concept of the liquidity trap, as outlined by Keynes, and developed by his early disciples, is one aspect of the theory of liquidity preference. Liquidity preference is a theory of the demand for money. Individuals have a certain transactions and a certain precautionary preference for holding money over bonds, because of  money’s property of liquidity.  They have a speculative preference for holding money over bonds when their expectations are that interest rates are likely to rise, bringing down upon the holders of bonds significant reductions in the value of their bond portfolios.

If this speculative fear is sufficiently high, the demand for money becomes infinite.  In such circumstances, the monetary authority cannot lower  interest rates on bonds by selling money in exchange for bonds on the open market. If this liquidity trap occurs under conditions of recession, the monetary authorities cannot stimulate the demand for investment by lowering bond rates of interest. In such circumstances, increasing government expenditures appears to be an attractive mechanism for returning the economy to full employment equilibrium. As Keynes emphasized, he knew of no such situation ever having occurred in the real world.

I do not know whether Paul Krugman has ever read Keynes’s General Theory;  but if he has done so,  he has mis-understood its message.  For what Paul Krugman identifies as a liquidity trap is a supply side, not a demand side phenomenon.  There is no evidence whatsoever that the demand for investment at current interest rates (incidentally Treasury notes with more than three years to maturity are nearer to 4 per cent than to zero in nominal terms,  Mr. Krugman) is inadequate to move the economy to full employment equilibrium. 

Evidence suggests that small firms are desperate for loans from the banks at current interest rates, but cannot obtain them because the big  banks will not lend.  The big banks will not lend, not because they are are short of high-powered money (Bad Ben Bernanke has drenched the economy in high-powered money), but because their balance sheets are rock-bottom rotten and they are trying to use Bernanke money to bring their financial ratios back from insanely low levels. The  big banks are in such a situation because they are loaded down with toxic mortgage-based securities despite Bad Ben destroying the balance sheet of the Fed in a buying spree of such assets that would put a drunken sailor to shame.

So the monetary problem confronting the Fed is not demand-based. It is not a liquidity trap problem at all. It is a money supply problem.  It is an inability to move high-powered money through the money multiplier into the supply side of the equation. The major error, both of the Bush and the Obama administrations, was a failure to allow market process to work, to allow the big banks to go under, to use FDIC insurance to move depositors into new good banks, unencumbered by toxic assets, yearning to make money by issuing good loans to would-be entrepreneurs.  The problem lies with government, with the Fed and with the FDIC who conspire to prop up failure and to impede success. Is that not always the socialist way, Mr. Krugman?  Is that not exactly why the collapse of the Evil Empire exposed the failure of socialism, and the success of laissez-faire capitalism? 

Is that not the fundamental fallacy of the conscience of a liberal  in the sense that you and other Americans misdefine that precious term, Mr. Krugman?

Hat Tip to Maggie