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Source link: http://archive.mises.org/9168/lucas-and-the-fed/

Lucas and the Fed

December 30, 2008 by

Writing in the Wall Street Journal on December 23, Robert Lucas expresses approval of the Fed’s latest reduction of its target range for the Federal Funds Rate to approximately zero, calling it “welcome.” Lucas notes that this policy does not leave the Fed without the ability to inject additional reserves into the banking system, because it can purchase not only Treasury bills, as it normally does in its open-market operations, but also longer-term Treasury securities and private bonds, which continue to trade at prices that imply substantially positive yields. Of course, Ben Bernanke has already hinted that the Fed is prepared to inject funds into the financial system in any way necessary in order to pump up spending.

Lucas finds the Fed’s actions in adding more than $600 billion to bank reserves in the past few months to be “the boldest exercise of the Fed’s lender-of-last-resort function” in its history. He believes, as I do, that in recent months financial decision-makers have engaged in a “flight to quality”–I call it a flight from risk–and that by injecting reserves into the banks, the Fed has effectively exchanged risky assets (the banks’ collateral securities) for a riskless asset (deposits at the Fed), thereby satisfying their demand to hold additional high-quality assets when the market itself was not supplying more such assets.Viewing the Fed’s action as an effective way to stimulate spending, Lucas also applauds it as superior to the alternative policies to achieve this objective. “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.”

I agree that these alternative policies are probably worse than direct Fed lending to the banks, but, unlike Lucas, I do not view the Fed’s abrupt, massive lending with equanimity. Indeed, as I indicated three days ago, I view the banks’ current, gigantic holdings of excess reserves as a veritable Sword of Damocles with the potential to cause a near-collapse of the dollar’s purchasing power.

I also differ with Lucas–and with Bernanke and nearly all of the mainstream commentators on the financial scene during the past several months–in that whereas he views the present situation as a liquidity crisis, I view it as fundamentally an insolvency problem for many banks and other financial institutions, inter alia. By treating this situation as if it were a liquidity crisis, like the banking situation from 1929 to 1933, one may moderate the recession for a short while or even reverse it, but only at the expense of preserving a plethora of malinvestments that ought to be liquidated by balance-sheet adjustments and, in many cases, bankruptcies, so that the valuable assets can be reallocated to their most valuable uses, rather than being kept impounded in zombie enterprises, including zombie banks. Because Lucas, in good mainstream-economics style, views the current situation in terms of aggregates, he is not looking inside the capital stock and therefore he is failing to see that the easy credit and reckless lending from 2002 to 2007 gave rise to a great many rotten investments that are not viable except by some species of Fed or Treasury bailout.

If the economy is to experience healthy sustainable growth, this garbage needs to be thrown out–and the incompetent managers and investors who created it need to be removed from positions of control over assets they have demonstrated they cannot manage responsibly and successfully. Free enterprise is a system of profit AND loss. If the government rides to the rescue of every large-scale, politically connected loser, the system will grow ever more rotten from the top down.

Yes, this way of proceeding entails short-run pain, but the alternative only pushes the pain into the future while ensuring that when it strikes, it will be even more severe.


Michael Smith December 30, 2008 at 3:00 pm

Thank you for the excellent article, Dr. Higgs. Can you comment on one thing?

I believe the 800 lb gorilla in the room that Bernanke doesn’t want to mention is the preposterously leveraged fractional reserve banking system.

Prior to this year, according to information at George Reisman’s web site, the banks had only about $40 billion in cash on hand against checking account deposits of some $2.5 trillion — a reserve of less than 2%. Obviously, no bank with so little in reserves can withstand any sort of run.

Then, for most of this year, the bank’s non-borrowed reserves actually went to zero and ran negative for a few months.

I, for one, am completely opposed to bailouts and agree completely with you that the “garbage must go”. But I’ve been wondering about the possibility that allowing these firms to fail might trigger massive bank failures that the FDIC and Fed cannot cover — leading to the actual disappearance of fiduciary media and an actual deflation.

Are you at all concerned about such a thing happening, i.e. an actual deflation? I’m referring of course to an actual drop in the money supply, not merely falling prices.

Thanks for all your work.

Joe Calhoun December 30, 2008 at 3:16 pm


The only reason to worry about deflation would be that the government would not allow wages to fall. That’s what happened in the depression and the result was massive unemployment. Absent wage floors (such as the minimum wage), an economy could adjust and work its way through a deflation.

Could the Fed make up for the destruction of credit? I don’t know….I’ll leave that one for Dr. Higgs.

Robert Higgs December 30, 2008 at 3:28 pm

Mr. Smith,

I view the likelihood of a substantial decline in the money stock (as measured by the usual monetary aggregates, such as M2) as virtually nil. The Fed has committed itself repeatedly to creating whatever amount of base money is needed to prevent that outcome. If for some reason the Fed should become unable or unwilling to carry out this promise (say, because the banks won’t lend or because the public takes flight to currency), I would expect the Treasury to issue fiat money directly, as it did when it issued the famous greenbacks during the War Between the States. In short, I do not expect deflation according to the Austrian definition; moreover, I do not expect deflation according to the now-current definition (a sustained, substantial decline in the general price level). I believe the deflation fears expressed recently are an overreaction to transitory events of the past few months. One may well doubt everything the government says, but if one is going to believe anything it says, then I suggest that one believe its promise to fight tooth and nail against deflation.

David Spellman December 30, 2008 at 3:39 pm

If massive bank runs and bank failures occurred, the government would simply manufacture fiat currency to cover the losses to depositors. Defaulting on the FDIC pledge would be very costly politically, so it simply won’t happen.

Of course, just because you get a check for the number of dollars you had in the bank doesn’t mean the money will still be worth anything. The government is already creating mountains of money with a bigger avalanche on the way after inauguration. Maybe we should actually follow the forlorn advice of pundits and spend our money while it still has any value.

Spend that dollar today or use it for toilet paper tomorrow!

Michael Smith December 30, 2008 at 3:44 pm

Mr. Higgs:

Thank you very much for the response. If there is little risk of a deflation, then I certainly see no reason not to, as you so aptly put it, “throw the garbage out”.

Thanks again for all your work!

Mick December 30, 2008 at 3:56 pm

Lucas ignores the posibility of the Fed just giving money to the banks without the pretense of a loan. Then it can inject all it wants.

joebhed December 30, 2008 at 8:07 pm


We all agree that something is wrong with the money system.
Even the criticism of the government is correct here, while mostly misplaced.
The FED is not the government.

Mr. Lucas is playing the role of the carnival barker of capitalism.
Or, more correctly, of the banking arm of the financial services industry.
As long as you buy his story, the show goes on.

Of course, Mr Higgs is correct regarding the nature of the financial crisis, with mountains of worthless debt that need to be repudiated, portending the real downfall of that same financial services industry.

We agree on that for sure.

And then we get into the consequences.
Here I split.
I think of the effects on people.
Mr. Higgs thinks of the effects on healthy, sustainable growth in commerce.

The consequence of the lack of a viable money system, based on a general banking failure were this debt-deflation to happen, is not acceptable to the people.
(That’s why the private FED keeps this up.)

Unless we want to discuss the international troops being deployed to prevent some unidentified social uprising, I think we should discuss the other options.
If there are any.

Thankfully, Mr. Higgs responds to Mr. Smith that he does not expect the debt-deflation that most see as obvious under normal circumstances.

” I would expect the Treasury to issue fiat money directly, as it did when it issued the famous greenbacks during the War Between the States. In short, I do not expect deflation according to the Austrian definition;”

Debt-free money.
Treasury issuance.
Now, we’re talking.
Add in 100-percent-reserve banking and we may have something to work with.
A way out of this friggin mess.
We still need to work out the quantity issue, I know, but it’s better than riots in the streets because the bankers destroyed the money system.

James Donnelly January 1, 2009 at 1:18 am


Sorry for truncating your comments below.

“Debt-free money. Treasury issuance……. Add in 100-percent-reserve banking ……..we still have to work out the quantity issue, I know, but it’s better than riots in the streets because the bankers destroyed the money system.”

I would suggest that if you add sound money to this prescription you have just described the current banking/financial elite’s worst nightmare.

Gary North, writing on the Mises Institute website, noted a sharp decline in Fed notes in circulation just before gold was hammered last year and then surprise, surprise after the TARP bailout is through Congress TMS starts to accelerate at a stunning rate.

My feeling is that the vested interests will “burn” your economy to the ground before they submit to meaningful reform.

If I am right on this score, how do you reform the system without “riots in the streets”?

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