Saturday, September 24, 2011

My Macro Questions for Prof. Robert E. Lucas

Some things do not change. Back in October 1988, I wasn't the best macro student in Prof. Lucas' class.  This morning I tried to raise my game and read through his interview in today's WSJ.    I didn't think it was a very informative interview.  Here are the questions I would like to ask him.

1.  Your work has highlighted the dynamic game that is played between optimizing consumers, firms and the government.  What "rules of the game" should the government commit to in order to raise long term growth?  Should the marginal tax rate on capital be zero?  Should we have a head tax per worker?

2.  If the policy rules you support exacerbate short run recessions, should government spend considerable amounts of money in the short run to bailout people who are suffering?  Are you a "tough love" guy?  Is that a time consistent policy position for politicians who must face the angry electorate? What stand do you take on unemployment insurance provided by the public sector?   How do you balance compassion for the suffering versus minimizing moral hazard effects?

3.  You and Paul Krugman seem to have very different visions of how our economy works.  Given that you are both Nobel Laureates, how can there be such a divergence in your respective views of the economy?   Are your differences with Prof. Krugman based on "science" or on personal tastes over the equity/efficiency tradeoff?   For example, Krugman appears to believe that there is significant duration dependence with respect to unemployment.  Intuitively, this means that the experience of being unemployed now makes you less likely to be employed in the future because your skills atrophy.  Do you believe this?  In your past work, you have famously argued that the welfare costs of recessions are quite low because the representative agent's consumption falls by about 2%.  Do you still believe your claims?

4.  In your work on rational expectations, you implicitly assumed that everyone agrees on the true probability distributions of future random variables such as the inflation rate or shocks to the economy.  In the real world, people disagree over their subjective assessments of the likelihood of future random variables (i.e what is the probability that unemployment will be 15% in the year 2013).   While it is difficult to incorporate such heterogeneous expectations into formal models, do you believe that this is an important research subject to explore.   Where does "confidence" come from?   How has Hansen and Sargent's work on robust control influenced your thinking about models of business cycles?

5. Building on #4, do you believe in the importance of social interactions across individuals? If my friends are pessimistic about our future, can this have a contagion effect on me such that I become pessimistic and change my investment plans accordingly?  In this case, what role does the media play here?  If we acknowledge this possibility, then do issues of multiple equilibria arise?  Can the government play a role in nudging us to a better equilibria in this case --- if it could "instill confidence"? I see from your piece in the Minneapolis Fed publication that you are thinking about "Bank Runs" and Diamond and Dybvig's JPE paper.  Doesn't this work harken back to multiple equilibria models that we weren't taught back in 1988 with the focus on the one sector growth model?  In graduate school, I recall that you didn't want to engage on the broad topic of self fulfilling prophesies.  What has changed your mind about the importance of this topic?

6.   If the Fed and Ben Bernanke acknowledge that they "know that they do not know" whether their policies such as QE and QE2 will be effective but they say; "we are running an experiment and will see what happens" , how does this influence models of private sector investment.  When the decision makers in the economy acknowledge that they are learning about a moving target,  what is the best response by optimizing consumers and firms to such fundamental uncertainty?   If the answer is delay (due to option value), what is the government's best response to the private sector's best response?   How do macroeconomists avoid being dragged into very messy game theory?