Robert E. Lucas: The Recession Is the More Immediate Problem

Robert E. Lucas, 71: In a financial crisis things happen fast, and the housing boom and the subprime mortgages are already ancient history.

The responsibility of the Federal Reserve in this situation is to provide more cash reserves, and in that sense they are doing their job. Total reserves were $47 billion on Sept. 10, $180 billion on Oct. 8 and $329 billion on Oct. 22. This is good central banking.

Should we be concerned that people will just hold on to the new reserves and continue to reduce spending? Some of that is surely happening, but more reserves can always be added.

Should we be concerned about inflation? Of course, always.

But right now the recession is the more immediate problem. If inflation resumes, reserves can be taken out as quickly as they were added. This is a classic lender-of-last-resort situation and it is important to maintain focus.

In my view, these are the most important considerations for US policy today. I think if the current Federal Reserve lending policies are continued aggressively our chances of avoiding a recession larger than that of 1982 are very good. At this point, I think this is the best that can be hoped for and it is a lot better than a replay of the 1930s.

The regulatory structure that permitted these events to occur will have to be redesigned, but this is not a job that needs to be done this week nor can it be done well in time to affect the current crisis.

The regulatory problem that needs to be solved is roughly this: The public needs a conveniently provided medium of exchange that is free of default risk or "bank runs." The best way to achieve this would be to have a competitive banking system with government-insured deposits.

But this can only work if the assets held by these banks are tightly regulated. If such an equilibrium could be reached, it would still be possible for an institution outside this regulated system to offer deposits that are only slightly more risky but that also pay a higher return than deposits at the regulated banks. Some consumers and firms will find this attractive and switch their deposits. But if everyone does, the regulations will no longer protect anyone. The regulatory structure designed in the 1930s seemed to solve this problem for 60 years, but something else will be needed for the next 60.

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