Why a Second Look Matters

This session was part of the CFR Symposium on a Second Look at the Great Depression and the New Deal, cosponsored by Dean Thomas Cooley of the Leonard N. Stern School of Business, New York University, and supported by a special grant from the Ewing Marion Kauffman Foundation.

This session was part of the CFR Symposium on a Second Look at the Great Depression and the New Deal, cosponsored by Dean Thomas Cooley of the Leonard N. Stern School of Business, New York University, and supported by a special grant from the Ewing Marion Kauffman Foundation.

AMITY SHLAES: Could everyone take a seat, please.

Good early afternoon -- good lunch. Thank you for coming to this, the center of our event today. I'm here just very briefly to introduce one of our supporters, Carl Schramm of the Kauffman Foundation.

Around here we think of the Kauffman Foundation as the "thinking foundation." Sometimes that "thinking foundation" sounds like an oxymoron. It's not, in the case of the Kauffman Foundation, which has been so generous in supporting us, at the Council, and this project, in particular.

Carl has his own book, "Good Capitalism, Bad Capitalism," one of many, which has helped us in our work on entrepreneurship, the subject of the Kauffman Foundation.

In addition, I'd like to thank Dean Cooley. I hope I see him, maybe -- there's Dean Cooley, who is the co-sponsor of this conference, from NYU Stern. We're very excited to be doing this with NYU.

So, I'll stop there and welcome Carl, who will introduce Dr. Lucas.

CARL J. SCHRAMM: Thank you, Amity.

I'm going to pull out my cell phone and tinker with it, to put it on "airplane mode." And this, of course, is a case example to all of you who seem to be sitting on your cell phones and not getting the point. Shall we? -- although, some of you may have already done it.

While I do this, I just want to suggest that there's a practical reason to do this. I was once giving a speech in Washington and the phone rang, and I cannot believe -- it was an audience twice the size of this, and I reflexively answered the phone. It was my son, then a freshman in high school, saying, "Dad, Dad, my bike's been stolen." I said, "Buy a new. Bye." (Laughter.) And I may have just saved myself another $500. (Laughter.)

Anyway, it's a great pleasure to be here to introduce Professor Robert Lucas. And in reading his own autobiography one has an appreciation of a couple of things. One, is his great respect for all of his teachers. To read it as a father, as a teacher, and as someone engaged in thinking about education and how to support it properly, it's a wonder to -- once again, it's always a fresh wonder to see someone reverence their teachers. And his autobiography is just a marvelous walk through an extraordinary set of figures who had an influence on him, and he was, and has been, so generous in recognizing their influence.

Along the way, in this biography, by the way, he -- there's another lesson, and it is that he actually loves books and credits the folks whose books have inspired him. And I stop there for a moment, because when one thinks about this, one thinks -- one reads this, or something like it, one thinks about the books that have influenced your own life. And I'm happy to say, with all sincerity, that I think of my 100 books -- which I've been keeping for a long time, once in awhile I have to displace a book because another book comes along that's a little bit more important. And I do believe that -- I had the -- I had the benefit of reading Amity's book, "The Forgotten Man" (in galleys ?)," and I knew the minute it was out in hard copy one of the others would have to go, because I think it's an extraordinary book, on its way to being a classic book.

And when Amity approached the Kauffman Foundation about this conference, it was a lay-up in the sense of it seemed an eminently smart thing to do, to bring people together to talk about the nature and the lessons of the New Deal. And if it looked like a smart idea back when Amity proposed it to us, it looks like yet a smarter idea given that this has now become a central topic.

Now back to Professor Lucas. I was trained as an economist. Recently, I changed my vitae to call myself a "cultural anthropologist." And the reason I do that is we've come, once again, to the moment when this most arrogant science, or pseudo-science, is caught with its pants down, literally or figuratively. We don't really know what we're talking about.

And while we might know, or pretend to know, what we're talking about in some areas, if there's one certain area we don't know much about -- and this is an area where Professor Lucas and several other economists are actually quite honest -- it is the question of growth, which is central to our dialogue today. And along the way, in crediting people who had influence on him, I love his phrase, that sometimes he pulls down Samuelson or William Feller's book on probability "just to enjoy their company."

I have personally enjoyed Professor Lucas' company in his lectures on growth. It's been a fascination of mine for a long time. It's the one single area where Nobelists, like Professor Lucas and Bob Solo, say again and again, "It's happened, but we really don't know why. Economists cannot solve this riddle."

And when I've enjoyed Professor Lucas' company -- I asked my research assistant the other day to actually do something empirical, and he said, "Yes, indeed, you have quoted him, this very phrase, three times in writing." So, I share with you, as the end of my introduction, the following phrase, which I think is pregnant with meaning for today; and it is important for all of us as citizens, when we turn to experts, to know what it is we don't know. But, in particular, this quote tells us something about the magic of entrepreneurship, the magic of firm formation, the magic of Schumpeter, in a sense of disrupting the economy, at moments like this, and letting the forces from underneath, in fact, create a renewal of democratic capitalism.

This is Professor Lucas: "For income growth to occur in a society, a large fraction of people must experience changes in the 'possible lives' that they imagine for themselves and their children. And these new visions of possible futures must have enough force to lead them to change the way they behave, the number of children they have, and the hopes they invest in these children, the way they allocate their time. In the words of a more recent title of Naipaul's economic development, it requires 'a million mutinies.'" This is, in fact, the moment we're in, and I think we couldn't do better to have as our after-dinner speaker, or after-luncheon speaker, Bob Lucas. Thanks so much for coming. (Applause.)

ROBERT E. LUCAS JR.: Okay, well, thanks very much.

And it's been a terrific -- I've been going to all the sessions, and it's a great conference. My head's spinning. Some of you will probably hear some of your best lines in my talk, for that matter.

I'm going to talk about the current situation in the United States. And, don't worry, the 1930s is going to play a role in how I, and everyone else, thinks about the current situation. It's one of the most serious recessions since the Great Depression of the 1930s right now, and there's no guarantee that it won't get worse.

At the end of 2008, U.S. GDP was about 5 percent below trend. People measure trends in different ways, but 2007 wasn't a great year either. The consensus forecast predicts something like 8 percent below trend by the end of this year.

Now, compared to the shortfall reached in 1933 -- the trough of the Great Depression, they were over 30 percent below trend. So these numbers now, it's a big -- big by comparison to the post-war recessions, but certainly nothing compared to the big event of the 1930s. And I don't want to let the parallels I draw to suggest that I think they're of equal importance or danger, but they're certainly a serious enough situation to get our attention.

And one of the lessons of the Great Depression, which has been discussed in many of the sessions today -- this morning, is that a side effect of depression is a proliferation of ill-conceived, hastily put together policies that serve to postpone the recovery. By 1940, seven years after the 1933 trough, the U.S. economy still had not gotten back to 10 percent below trend. And there's really been nothing like this before or since in any industrial society, as far as I know.

The current crisis has given rise to an orgy of finger-pointing, and this activity may well contribute to sometime -- some day to reasoned diagnoses that help us to redesign the financial regulatory system, which everyone knows we have to do. But, this exercise, which is important, is almost completely unrelated to the more urgent task of organizing our thinking about what, if anything, should be done right now to deal with the recession. So, I'm going to set aside the hard questions of moral hazard and incentives -- which are central to the regulatory problems, set them aside and just think about the basic arithmetic of what we might call -- and this is a -- the due irony -- "monetarist fine tuning."

So, now, some numbers. The trend growth rate of the U.S. economy is 3 percent per year -- I'm talking about total GDP, real GDP. And we always -- we keep returning to it, it's been our -- the norm for well over a century. But, suppose right this minute GDP is 6 percent below the trend line? Then to recover in three years, to get out of a recession in three years, we need three years of 5 percent growth -- 3 percentage points just to keep up with the trend; and 2 percent, three times in a row, to get, to make up for the 6 shortfall. So, that's what it means to get out of a recession like this, roughly speaking.

Now, in a free society the growth rate of real GDP is not something anyone can choose -- any individual or government can choose. What we can choose, though -- and this is roughly speaking, we've had some debates about that this morning, what we can choose is the growth in the dollar value of GDP. The growth of GDP in dollars is more or less directly influenced by monetary policy.

So I'm going to talk in terms of choosing -- (inaudible) -- say exaggeration, the rate of nominal growth, and then the real growth rate and the inflation rate have to add up to that thing. So we can, kind of, choose the sum of the inflation rate and the real growth rate. So from that point of view, if you want 5 percent real growth, and we're going to have an inflation target of, say, 2 percent, then that nominal growth is going to be -- we're going to have three years of nominal growth at 7 percent.

Now, the fact is, we don't have any reliable way -- Mr. Schramm talks -- (laughs) -- talks about what economists don't know, and my talk's going to be full of instances -- we don't have a reliable way of relating changes in monetary policy to changes in nominal GDP growth in the short-term. And we can't predict exactly how nominal GDP changes will break down into real growth and inflation.

But, let me review how this breakdown worked in the 1929 to 1933 period, the period that Milton Friedman and Anna Schwartz called "the great contraction," in their monograph, "A Monetary History of the United States." This is a 100-page chapter, and you should read -- anyone interested in recessions, depressions, and depression prevention, and -- (inaudible) -- should read this chapter, if you haven't. Most of you have already.

Okay, over this four-year period -- I'm just summing up -- nominal GDP fell by 58 percent; real GDP fell by 34 percent. And then, because -- and then inflation -- the prices -- (inaudible) -- you already know this, because of it's adding up condition, must have fallen by 24 percent. And that's about right.

You can divide these numbers by four to get annual rates. And when you do that -- you know, in fact, the decline took place gradually, there wasn't a meltdown immediately following the stock market crash. In fact, the first year after that was rather -- the economy was rather modest -- but it added up to four years of negative growth averaging minus-8 percent a year. Not too many people have ever lived through that -- such an event, in this room.

Now, the Federal Reserve didn't cause this decline. When it began, it was an increase -- a reduction in velocity, a "flight to cash," people called it. My guess is, it was a part of a fear -- people seeking safety in liquidity after the stock market crash, or any event. In any event, people cut back, built -- wanted to build up their cash holdings.

Now, the Fed could have responded to that situation by -- the people want more liquidity, by creating the reserves that -- the new money to supply the added liquidity. In which case, people wouldn't -- would not have had to reduce spending in order to build up their cash. Now, you can try building up your cash by buying securities, but everybody can't build it that way because we're all doing the same thing.

So, really, the only way to respond to this demand for liquidity, if the Fed doesn't do anything, is individuals have to hold on to cash coming in, and resist spending. And that's the depression. That's that depression -- that's the monetary side of a depression

But, the Fed didn't do anything to relieve this liquidity. They sat by. And they cut interest rates time zero. They were, I guess, the believers that the only thing is -- monetary policy can do is fix interest rates. And once interest rates get to zero, you're over.

Now, Friedman and Schwartz, one of their main theses is that this passive response by the Fed must bear the ultimate responsibility for the severity of the contraction -- that they couldn't ease, you know, at any point during that four-year period, and stop the hemorrhaging, and they just did not do it. And if the Fed has the ability -- and, I would say, the responsibility to do that, and they didn't. So even today, many people think of the Depression as evidence that monetary stimulus is ineffective when the real problem was that it wasn't used.

Now, this is one policy mistake that's not going to be repeated in the current situation. The Fed, under Bernanke's leadership, had added something -- I never know quite know what number to say, I'll say 600 billion (dollars) in bank reserves, but he's lent money to other companies and don't show up in this decision I'm looking at.

This $600 billion is -- this is a system that operated with $50 billion in reserves last August. So, I mean, it's just a mountain of new reserves. Now, the size of these actions -- and they're going to get bigger we're told -- and the nature of the assets the Fed has bought, has been controversial; you know, how could it -- how could it not be? You can't spend a trillion-plus (dollars) without raising a few eyebrows.

So I want to tell you why I think this is the right thing to do and what's the case for it. So nominal growth -- my argument before, my sketch of the hypothetical three-year recovery, said that something like a 7 percent growth rate in nominal GDP would be helpful. The nominal growth is way below 5 percent, or even 3 percent at an annual rate right now, and the forecasts for 2009 are for near zero growth.

So if we don't change the rate of growth of nominal income, and we want to get a 5 percent real growth, we're going to have to have an offsetting deflation of 5 percent. And these things have to add up. And that's just not going to happen. It is not possible to pull a modern economy through a neutral or painless deflation. Economic theory doesn't really tell us why -- what's hard about it. But, the evidence, I mean, it just doesn't work.

I think the long, drawn out recession in Japan is exactly because the nominal income in Japan has grown at something -- you know, for 15 years at rates that average somewhere between 1 (percent) and 2 percent. Now, if you're going to get 3 percent real growth, that means you got to have a negative deflation for all those years, and it just doesn't -- it hasn't been good for Japan. Those numbers are much smaller than the 1930s, but it's a serious -- it's a serious mistake.

Now, the additional reserves the Fed has put into the system have induced double-digit growth in M1 and M2 domain monetary aggregates. And these are rates which, I think if they were sustained, would soon yield inflation at 1970s levels or higher. And, moreover, as confidence returns, which it will, velocity is going to return to pre-crisis levels and people are going to start spending more out of their cash balances. So, inflation's going to -- that too is going to add to the inflationary pressures.

So, it's absolutely necessary for the Fed to be able and willing to reverse course and sell off the assets its acquired over these years, to keep this inflation -- the inflation is going to get out of hand. This is almost -- we don't know when that it's going to hit. I don't see any reason to start cutting back now because you're going to hit it. But, it's something you might as well think about it, because we're going to get there.

There's nothing technically hard about unwinding these Fed positions fast. And the markets you need to operate in to do that -- the Fed needs to operate are there and working. But, it's going to take political courage, or some kind of consensus -- the kind of courage that Paul Volcker showed in the 1980s when he brought -- adopted policies that brought the 1970s inflation to an end, that same kind of courage and independence is going to be called for in a few years. I don't think it's an argument against the policy that's being followed, and I hope, when the crunch comes we'll do the right thing, but it's a concern that everyone who's watching these policies has, and we'll see.

We had some lively sessions this morning about fiscal stimulus. Now, would a fiscal stimulus somehow get us out of this bind, or add another weapon that would help in this problem? I've already said I think what the Fed is now doing is going to be enough to get a reasonably quick recovery committed. But, could we do even better with fiscal stimulus?

I just don't see this at all. If the government builds a bridge, and then the Fed prints up some money to pay the bridge builders, that's just a monetary policy. We don't need the bridge to do that. We can print up the same amount of money and buy anything with it. So, the only part of the stimulus package that's stimulating is the monetary part.

So it's a mistake to think of two different ways -- there are two different ways of getting the cash out there. Maybe some of the things Bernanke's doing right now to get the cash out there are properly called fiscal policy. I'm not sure even what the -- somebody raised the question of the definition of these terms that are -- in the morning session. I thought it was a pretty good question. I'm not sure either.

But, if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder -- the guys who work on the bridge -- then it's just a wash. It has no first-starter effect. There's no reason to expect any stimulation. And, in some sense, there's nothing to apply a multiplier to. (Laughs.) You apply a multiplier to the bridge builders, then you've got to apply the same multiplier with a minus sign to the people you taxed to build the bridge. And then taxing them later isn't going to help, we know that.

So I think this monetary response that we're in the middle of now, I think it is a response to the lessons of the 1930s. It's not the whole problem of the 1930s, because there are all kinds of policies that were crucial to that evolution, that monetary policy's not going to touch, and didn't touch in the 1930s. But, I think the monetary -- in terms of the stimulus response, if you could -- a stimulus to get -- help us accelerate the recovery, I think the current policy we're doing is the right one, and I just hope that we have the nerve to terminate it when it's done its job. Thank you.

(Applause.)

(Mr. Lucas apparently trips on the stairs.)

SCHRAMM: (Off mike.) Are you okay?

LUCAS: Yeah.

SCHRAMM: All right.

LUCAS: It wasn't exactly a subtle step, was it? How the hell did I miss it? (Laughter.)

SCHRAMM: A year ago the Council could afford another stair. (Laughter.)

We're going to take some questions, but as you formulate a question I want to ask you to recall that this may be on television and you have to call for a microphone. So we have folks who are ready to bring microphones to you. And before the first question comes I want to ask you this question.

You know, it strikes me that Schwartz and Friedman had economics on a vision of what had happened if we would redo the recession from -- excuse me, the Depression from a policy perspective, and for perhaps the last 20 years there was sort of a resurgence of Schumpeter's view of where the economy was headed. There was a new respect for the dynamism of entrepreneurs. And then overnight we're watching the revision of what we know into sort of a Keynesian model. And I'd like -- this is sort of an epistemological question to an eminent economist -- how is that we are so undetermined as to what these policy prescriptions in the history -- in the lessons of history are?

LUCAS: That's a tough question. I mean, Schumpeter and Keynes are two economists I've always had trouble understanding. I see the situation here as in -- in its economic essentials very similar to the one that Friedman and Schwartz talked about. I know Anna doesn't see it this way but I see the parallels as being very close and I don't see why can't I just take that book off the shelf and see what we did in the 30s and go with it.

I don't -- I don't know. I don't think you have to be fancy about the nature of economic growth in the real economy, which is what was Schumpeter's main interest, and I think Keynes was one of those who thought that when the interest rate was down to zero monetary policy was over and I think that's wrong. I think that's one of the things that Friedman and Schwartz showed. So I think it's a monetary stimulus of the sort that leaves doubt. I think Bernanke agrees with this.

He's also very much concerned with somehow fixing up the banking system, which may be -- it's his job, but I -- I'm just talking about the -- getting the reserves out there as a stimulus to spending. I think we know enough to do that. Hope we do.

SCHRAMM: Ben? Could you tell us your name?

QUESTIONER: Ben Steel, Council on Foreign Relations. Bob, I edit a journal called International Finance and I get a lot of submissions from people who build big models -- big economic models -- and the shortest referee reports I get back condemn these submissions by saying this model is subject to the Lucas critique. In the last session, we had quite an animated discussion which spilled over into the lunch about models on fiscal multipliers, what they are.

On the one extreme, we have models by people like Mark Zandi at Moody's who say that the fiscal multiplier for the spending initiatives we're discussing are on the order of 1.5. On the other hand, we have people like Robert Barro at Harvard who say there's zero or negative. How would you go about applying the Lucas critique to these types of models to sort of educate us in how we should think about the validity of these models?

LUCAS: Do I need the Lucas critique for -- I'm with Barro is the short answer. (Laughter.) The Moody's model that Christina Romer -- here's what I think happened. It's her first day on the job and somebody says, you've got to come up with a solution to this -- in defense of this fiscal stimulus, which no one told her what it was going to be, and have it by Monday morning.

So she scrambled and came up with these multipliers and now they're kind of -- I don't know. So I don't think anyone really believes. These models have never been discussed or debated in a way that that say -- Ellen McGrattan was talking about the way economists use models this morning. These are kind of schlock economics.

Maybe there is some multiplier out there that we could measure well but that's not what that paper does. I think it's a very naked rationalization for policies that were already, you know, decided on for other reasons. I don't -- I'd like to talk about the Lucas critique but I don't -- I don't think we can -- (chuckles) -- deal with that issue.

SCHRAMM: Question here, sir?

QUESTIONER: Thank you. Malcolm Wiener. I suppose one way to think about fiscal stimulus is to ask when is the right time to build necessary infrastructure -- when the government is during a boom, when the government is competing for labor and capital with private industry, or during a recession where that's available, and I would point you to one answer. One of the critiques raised is that it can't -- the fiscal stimulus can't act quickly enough to help in this situation, and I suppose if we're in a standard cyclical recession that's true.

But the real risk is that we may be in for U- or an L-shaped recovery in which case the fact that some of it doesn't kick in until subsequent years is not only less troublesome but perhaps beneficial. And then, of course, that brings me to the final point. If this is -- well, much of the discussion this morning has been in terms of a severe cyclical event but if this is also a structural event with the savings rate going from minus something or other back to traditional levels of 7 (percent) or 8 percent as persisted during the 50s or even back to 10 or 12 percent because people are so shocked by what's happening to their savings, then I wonder if any amount of monetary easing or quantitative easing interest rates are already zero would be enough without some fiscal stimulus.

LUCAS: That's a long question. I'll start from the back and I'll forget to get all the way through. The zero interest rate thing is -- there no -- look what Bernanke's done already. After interest rates hit zero he's putt $1 trillion-plus into the economy. So no one's ever going to -- whatever happens in this -- whatever Ben's does -- done for us he's completely removed this zero interest bound as something we have to think of as a limit on what monetary policy can do.

I think if you had to do something -- I mean, you're saying a slump is probably a pretty good time to build stuff with government programs. I mean, the construction industry is slumping, wages aren't going to be going up fast, so we could take advantage of that and build some roads. That's true in the private sector too. It's a great time to buy a new car. I mean, it's a great time to do a lot of things. But people aren't -- so I think these incentives are not -- they're a force that's going to bring a private response. You're describing if the interest structure thing is analogous to a -- I agree with that.

I certainly don't think, you know, it would be a bad idea to build some new bridges. But that's got to be justified not on stimulus or multipliers, just on the fact that we'd like better bridges and we're willing to pay for it if we are. Now, right now maybe is not -- I don't think the government's exactly flush but, you know, I think those are the issues to talk about and I certainly don't think -- obviously, the role for government in providing infrastructure is really central to the whole process.

SCHRAMM: Question in the back.

QUESTIONER: You suggested that we could just take Friedman and Schwartz off the shelf and apply the lessons today. I'd like to suggest there's a one -- at least one key difference between the 30s and today, and that is in the 1930s there was no deposit insurance. There are no doctrines of too big to fail. So what's happened in the current crisis is that we've been -- insured the banks.

They've reduced the amount of capital they hold and there's been increased risk taking so that the size of the losses are, at least by my calculations, in the 30s were about 2 (percent) to 3 percent of GDP, now well above 10 percent of GDP. It becomes a question of how you're going to actually distribute those losses in part of this -- problem of the dialogue is we're talking about bailing out banks instead of bailing out depositors, which is really what's going on I think.

But the real question becomes one of political economy because you have to -- before you can resolve the question of the banks you have to resolve the question of who's going to pay for them -- pay for -- pay for the -- pay the cost of shutting down the insolvent banks.

LUCAS: I avoided this bank bailout issue in my 15 minutes and there's a reason for it. I don't really get it. Some of the problems you're talking about about deciding who gets paid and who doesn't, that's the whole function of bankruptcy law is to deal with that in an effective way. Now, it may be that the kind of neighborhood effects of the bankrupt banks are sufficiently different from the neighborhood effects of a bankrupt auto company -- that they need some kind of special treatment.

But then it seems like the right public policy is something that -- maybe some kind of accelerated bankruptcy proceedings. Just to say make them well on all the money they've lost over this thing, I just -- I do not get it and I know of -- I don't know whether we're headed that way or not. I hope not. Now, what was the first part of that? (Off mike exchange.) Oh, the differences with -- I did want to say something.

I think Friedman and Schwartz have got a lot to tell us about the current situation. There's certainly plenty of differences between the '29 to '33 period and the present period besides magnitude, the whole role of who provides liquidity which was then more or less completely confined to cash and commercial bank deposits as, you know, partly because of the '70s inflation spilled out into the shadow banking system, which is, you know, unregulated and which the Fed has no special responsibility for. And so there's been a lot of improvising in that dimension.

I said I was going to not deal with moral hazard. This is not the right time to worry about too big to fail, you know? What I'd say now is the failure of the bank is going to cause spill over effects that deepen this recession and so on, it's now -- keep them alive. We're going to come out of this with a new regulatory structure, a new set of incentives and we're going to have to kind of start from scratch anyway. So in terms of you bailing out a bank and setting up incentives for the next 30 years for bank behavior, that's not what's going on right now I don't think.

QUESTIONER: Bill Beech from the Heritage Foundation. The other side of fiscal policy is tax policy, the other side of spending is tax -- as apart of fiscal policy. What's your view right now as to the appropriate tax policy we should be taking?

LUCAS: Again, I think it's -- I didn't like it when the Bush Administration talked about tax cuts because it was going to jumpstart the economy. I liked the Reagan/Bush tax cuts, I like reducing marginal tax rates on -- you know, the tax on savings basically. But that just like the bridge building, it's not something specifically tied to the present recession. You know, he likes -- wants new bridges, so let's build one now. I like long term tax cuts so let's do that now, but let's not pretend that we're doing it primarily for temporary recovery from this recession. We're doing it for more deeper reasons, I think. You see what I'm saying? When you sit down, I lose track of who I'm speaking to. (Laughter.) Kind of melt into the crowd.

QUESTIONER: My point is when is the best time to do it?

LUCAS: Yeah.

QUESTIONER: (Off mike) -- competing for labor and capital.

LUCAS: You know, what I think -- I'll tell which thing is this -- we're going to build the bridges now so they won't be worn out five years from now and so we'll cut a tax cut or we'll redeem the bonds, the bridge bonds during that period when all our bridges are in tip top shape and we don't have to build any. Just move the financing and the building across time. And that makes some sense. But, anyway --

SCHRAMM: Jonathan, you have a question here.

QUESTIONER: I'm not sure I understand you quite right on the bank bailouts. You think that the bankruptcy laws should just be able to take effect in regular course, let them go bust, and then reorganize and --

LUCAS: No.

QUESTIONER: -- move on with a new regulator regime? Wouldn't the lag time --

LUCAS: All I said --

QUESTIONER: Yeah, that's why I'm not quite sure I understood your answer to -- I know you wanted to avoid it in you 15 minute speech but --

LUCAS: No, no. I --

QUESTIONER: -- little more clarity on what you think we should do about the banking crisis and whether you think the PPIPs are the right way to go right now.

LUCAS: Well, the bankruptcy will work perfectly and smoothly in simply transferred assets, productive assets that people can use them better than I -- but bankruptcy is a slow process and it's a complicated process and it's a process that I don't know anything about. So people who do know about it are reluctant to just let that happen.

So I think if there's a reason for that, I think it must be because they're not happy with the -- and you seem to say the same thing, you don't think that the existing bankruptcy law and procedures are up to the job for, in this situation.

QUESTIONER: I think the argument is --

LUCAS: So maybe --

QUESTIONER: -- of time elapsed; in other words, if job one is to get credit flowing again, you got to get the toxic assets off the balance sheets so that these banks can start lending to other banks which can then in turn lend to businesses and people so that the economy can head up again.

(Cross talk.)

LUCAS: It's just a non-sequitur.

QUESTIONER: So you don't think the --

LUCAS: You don't have to fix up every bank in the United States just to get credit flowing. Credit's going pretty well right now, and if half the banks went under, the other half would take over the business. Bankruptcy doesn't take bankers and their equipment out and shoot them or anything. It just transfers -- (laughter) -- control from the current shareholders to a new crowd. My bank's changed names five times in the last 10 years and they didn't miss a beat.

SCHRAMM: Question in the back.

QUESTIONER: Bob James, I'm a businessman. You mentioned Shumpeter here a couple of times and I happen to have studied under him, and I know there's one thing you can be sure about, he would have agreed with you that taxing to me to get government to spend money, he did not think was very effective. As for the Caines(ph) and multiplier and so on, he didn't talk too much about that. And I don't blame him because I don't remember anybody at Harvard at that time, this was right after the war, that paid any attention to Shumpeter. I was a Harvard Business School graduate at the time and some of what he had to say sounded very, very good to me.

So question, what do you think he would recommend at this time?

LUCAS: I should ask you or Carl. Between the two of you, you could probably answer that question. I just haven't any idea.

(Laughter.)

SCHRAMM: Well I think that --

LUCAS: (Inaudible).

MR SCHRAMM: -- Shumpeter would be telling us that we're missing a particular ingredient in this economy, and that is the entrepreneur. And we've had a surge of what has been called, and I'm complicitous in this description, entrepreneurial capitalism, the nature of capitalism to some extent has changed in 25 years. Unless you discard that, appreciate that there are a lot of people who are ready to discard capitalism at the moment. It is a dynamic and robust, but not unwoundable social or economic phenomenon. But that's what he would be pointing to and I think his impulse would be to say the notion of too big to fail if we execute that you basically buy into slower growth rates because it will dampen the ability of firms to undertake the transformation of the economy.

Last point I'd end with is this, one third of GDP when we used to have growth in GDP -- (laughter) -- one third of our GDP, static GDP, comes from firms that did not exist in 1980.

LUCAS: Yeah, bankruptcy's the American way of life. Think of all the great corporations that have disappeared in our lifetime. Oh, I'm sorry.

SCHRAMM: Yeah, go ahead sir.

QUESTIONER: Bob Lifton. You start with a concept of a norm of GDP growth. It seems to me that in the last number of years it became clearer and clearer that the business model for America is under question. And the question is what is the growth of America? Where's it going to come from? And can you make an assumption of a normal GDP?

If you were to erase the last five to seven years of overstimulation and over borrowing and the craziness that went on, I don't know what the real GDP would have been during that period. And I think when you look forward, you have to ask yourself the question what is the basis for our growth as a country? Maybe the entrepreneurship can help but I don't know what the normal GDP is anymore.

LUCAS: Well, I'm not doing anything fancy, I'm talking about the average growth rate in the United States, I think in my last calculation from 1870 to 2006. And that's 3 percent.

If you look at subsets of that period, for example, in the 1920's and the 1960's are both on that same curve and so after all of the displacements from during the Depression in the '30s and World War II, we can back to essentially the same trend line that, there were some forces that are bringing us back to that trend line, or close to it.

So I just think it's part of the system. Now, is it going to be continuing? Who knows? You know, I just don't -- I don't see how you can answer that question.

QUESTIONER: (Off mike.)

LUCAS: That term's kind of used a lot of in the shares, you know, the share of manufacture shrunk, the share of agriculture shrunk, the share of services grown, that's -- (inaudible) -- change, certainly happened.

Certainly a lot has changed, I mean, our world is a heck of a lot different from what it was in 1928, no one denies that. But the stability in real GDP growth is -- it's been around for a long time.

QUESTIONER: (Inaudible.)

LUCAS: Well what about that?

QUESTIONER: (Inaudible). I mean, it was based on the belief system that what happened in the past will happen today --

LUCAS: Sure.

QUESTIONER: -- but the world, but our world has changed dramatically and the question is whether that belief system is still reality?

LUCAS: Mine's still going strong. (Laughter.)

SCHRAMM: Seen a black swan lately? We have a question here.

QUESTIONER: Chuck Rooney (sp). I wanted to ask about your concept about taking the punch bowl away, and we could get a consensus how to do that. And I thought as I recall Volker didn't want to take the punch bowl away and he went to the BIS meeting in Bucharest or Budapest wherever it was, and they put the slam on him. And he came back and he really slowed money growth. And did Premier Wen Jiabao do the same thing for us recently. Do we need a consensus or do we have Wen Jiabao?

LUCAS: Okay. My -- I believe Volker and I was reinforced by talking with Alan Meltzer who knows more about history of the Fed than anybody I know. His view is Volker's a courageous guy who did the right thing because he believed it was the right thing. And then he got supported by President Reagan because the Federal Reserve is not -- independence is not something that's going to be there automatically forever. And, you know, I don't know the detailed history of that at all, besides what Alan tells me. I don't know if --

SCHRAMM: Question here.

LUCAS: Uh-oh. (Laughter.)

QUESTIONER: Ed Prescott, Arizona State University. There's one area I'm a little bit confused. there seem to be that a little shuffling of assets -- you know, I own a little bit less of some, a little bit more deposited in the bank's going to make much of a difference at all. There's plenty of assets out there for the transaction purposes and it just A goes up and down; B goes down and up on the two assets.

LUCAS: What do you mean by asset?

QUESTIONER: I don't see how the money does anything real.

LUCAS: What do you mean there's plenty of stuff out there? Like we could all sort of start trading in gold?

QUESTIONER: I'm saying that I -- when the Fed gets my junk bonds, and I get deposits in my bank, where's the -- it's just changing my portfolio a little bit, changing the Fed's a little bit, and I guess our banks -- and my bank's portfolio. These are all -- there's nothing real. They're just bookkeeping entries, I mean, sort of shifting assets around.

LUCAS: Shifting assets around when liquidity's involved -- I mean, is seems like what you're saying is that Lehman Brothers couldn't have failed. Liquid assets have the property that -- I hold them because I know I can pass them on to the next guy. Why does he take it? Because he knows he can pass it on to the next guy. And that's true of U.S. currency, I'm going to go take my money into Walgreen's, you know, and get in an argument about whether or not they're going to accept it or not.

But all these probably created liquid assets seem to me to be analogous to kind of unregulated money or private money -- used to be called inside money. And it does matter.

SCHRAMM: John, we have a question in the back.

QUESTIONER: John --

(Cross talk.)

LUCAS: -- let me off that easily. (Laughter.)

QUESTIONER: Yeah, I guess I was going to continue on that. You mentioned money deposited in banks and to me, money saved, how can it possibly detract from demand? If that money is in a bank, it has to be lent out preferably to an entrepreneur or business but it might be lent out to someone who's got immediate consumptive needs. What difference does it make where the money is?

LUCAS: I thought that was my line but -- (laughter) -- a lot of people say -- and I think this is something to think about, you see if you agree. This huge amount of reserves that Bernanke's put out there is almost all still in the banks. So there's huge excess reserves in the whole banking system. So it's not like the days when that reserve constraint was binding and new reserves get turned into demand deposits and M-1 quickly. That's not happening anymore. But nonetheless -- so the growth in M-1 and M-2 is nowhere near what it would've been if people had been lending out up to the reserve requirements.

So you have to look at separate numbers to see if it's coming out in people's actual cash balances, and it is, but not nearly as much as you'd get from looking at the size of their reserve injection.

So we're talking about spending, I think people's cash balances are related to their spending behavior and it's got -- so if it's just sitting in banks, not effective business or individual behavior, it wouldn't do anything I don't think. Caines used to talk about that as hoarding -- you know, if people take their money and stick it in a mattress, it might as well not be out there. Does that make sense?

QUESTIONER: I guess I just think as long as it's in the bank, it doesn't make any difference, unless you are putting it under a mattress, you are not hording it. And if banks are restricting their lending, that is a market signal that we have to respect I think that says that we are going to be more judicious about lending that out and that means that it gets to the right people rather than just aggressively lending for no good reason.

But once it's in there, it's got to go somewhere.

LUCAS: I don't think, well, maybe so, I don't know.

SCHRAMM: Well, we're coming to the end of our session and I'm going to reserve the right for the last question and here it goes with great trepidation.

You know, if you're with an eminent economist, and someone asks with the first question, well what about the Lucas air term (ph), you are greatly worried about asking a question like this because I'm going to talk -- I'm going to ask about the Lucas paradox. And, you know, economists -- when in the presence of an eminent economist -- not like surgeons, you know, I cut up people as good as you do -- but real economists who can call other economists schlock economists have to once in awhile tolerate a question from the meatball economist. And here it goes.

The Lucas paradox, as I understand it, suggests that poor countries do not draw the capital that they should given their human capital and natural resources reserves that they should rationally, that money from richer countries should go from their investors to poorer countries because of these advantages. But they don't happen, according to the Lucas paradox again, with all my caveats but I may not understand it just right for two reasons, one of which is sovereign risk.

And the question that I put -- I think it rings with the question back here that Mr., I believe, Bernie asked and we wait for the Chinese to push this question at us. What is the sovereign risk assessment these days when a government might move forward and at least the theater of the government today is they're determining who will be president of General Motors.

Does this dampen people's certainty about how the rules work neutrally or are our rules looking as if they are politically driven?

LUCAS: Sure. I mean, that's a central issue right now isn't it with the bank bailouts, you know, large amounts of money's being handed out to private corporations, and without any particular structure to it. It's certainly not something you want to live with forever on the long run.

When -- one of the things we came out -- (inaudible) -- in the New Deal was Glass-Stegall and some kind of banking regulation structure that let us have a safe banking system and an innovative financial sector outside the banking system. Seems like that combination has to be re-established or something like it now because the present -- the way the Fed is operating right now is definitely not something that we want to carry in day in and day out, is it?

SCHRAMM: Yeah, but it -- it probably goes to this question of we now have a new term in the last 10 days, systemic risk --

LUCAS: Yeah.

SCHRAMM: -- and some institutions are holders of systemic risk and we have to shelter them differently than other institutions which presumably are not so systemic.

LUCAS: Yes. What Glass-Stegall did was to take the commercial banking system, insure it, regulate it, and in particular put serious restrictions around the kinds of assets in a hold. And the idea was that the team of certain amount -- it had to be done through the commercial banks so it was going on outside and the investment banks and investment sector were something that didn't have anything to do with liquidity provision or the payment system. And that was kind of more or less true for years. I mean, there hadn't been a run on commercial banks since the 1930s.

But it wasn't true that the liquidity provision could stay within this regulated sector, it was too lucrative to pull out of the regulatory sector and put some of those funds into higher yield assets.

Now select Fed -- regulation is no longer functional. If it were we wouldn't be in this situation I would say. So somehow -- this is not going to be easy. You can't -- we can't just regulate institutions by their names -- commercial banks can do this, other -- you know, you've got to describe the functions that are being regulated. You can't just change -- if you just change the name of your company, it shouldn't liberate you from regulations.

So that problem is still in front of us. And I think it's a good one. I mean, I don't know how it's going to be resolved. Maybe we'll go back to Friedman's old scheme of 100 percent reserves, that's a regulation for you -- (laughter) -- outlaw modern banking entirely.

SCHRAMM: Well, on that happy note, I want to thank you -- (laughter) -- on behalf of the audience. (Applause.)


(C) COPYRIGHT 2009, FEDERAL NEWS SERVICE, INC., 1000 VERMONT AVE.
NW; 5TH FLOOR; WASHINGTON, DC - 20005, USA. ALL RIGHTS RESERVED. ANY REPRODUCTION, REDISTRIBUTION OR RETRANSMISSION IS EXPRESSLY PROHIBITED.

UNAUTHORIZED REPRODUCTION, REDISTRIBUTION OR RETRANSMISSION CONSTITUTES A MISAPPROPRIATION UNDER APPLICABLE UNFAIR COMPETITION LAW, AND FEDERAL NEWS SERVICE, INC. RESERVES THE RIGHT TO PURSUE ALL REMEDIES AVAILABLE TO IT IN RESPECT TO SUCH MISAPPROPRIATION.

FEDERAL NEWS SERVICE, INC. IS A PRIVATE FIRM AND IS NOT AFFILIATED WITH THE FEDERAL GOVERNMENT. NO COPYRIGHT IS CLAIMED AS TO ANY PART OF THE ORIGINAL WORK PREPARED BY A UNITED STATES GOVERNMENT OFFICER OR EMPLOYEE AS PART OF THAT PERSON'S OFFICIAL DUTIES.

FOR INFORMATION ON SUBSCRIBING TO FNS, PLEASE CALL CARINA NYBERG AT 202-347-1400.

THIS IS A RUSH TRANSCRIPT.
-------------------------