What Are Chicago's Economists Thinking?
I am watching Eugene Fama, Robert Lucas, and now John Cochrane stagger around assuring everyone that fiscal policy cannot boost employment and production--no matter how high the unemployment rate and how much unused capacity there is--as a matter of "just accounting" that "does not need a complex argument about 'crowding out'":
John Cochrane: Most fiscal stimulus arguments suffer from three basic fallacies. First, if money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both. This is just accounting, and does not need a complex argument about “crowding out”...
Cochrane is at least superior to the other two, in that he does concede that there is an (unlikely and inapplicable) case in which fiscal policy might have some impact--if people are acting "pathologically":
[S]uppose... people or banks... are pathologically sitting on cash.... Suppose the government could direct that money to people who are willing to keep spending it.... This is not a convincing analysis of the present situation however...
And I can barely believe my eyes.
Paul Krugman provide me with welcome assurance that I have not gone crazy:
A Dark Age of Macroeconomics: Brad DeLong is upset about the stuff coming out of Chicago these days — and understandably so. First Eugene Fama, now John Cochrane, have made the claim that debt-financed government spending necessarily crowds out an equal amount of private spending, even if the economy is depressed — and they claim this not as an empirical result, not as the prediction of some model, but as the ineluctable implication of an accounting identity. There has been a tendency, on the part of other economists, to try to provide cover — to claim that Fama and Cochrane said something more sophisticated than they did. But if you read the original essays, there’s no ambiguity — it’s pure Say’s Law, pure “Treasury view”, in each case....
What’s so mind-boggling about this is that it commits one of the most basic fallacies in economics — interpreting an accounting identity as a behavioral relationship. Yes, savings have to equal investment, but that’s not something that mystically takes place, it’s because any discrepancy between desired savings and desired investment causes something to happen that brings the two in line. It’s like the fact that the capital account and the current account of the balance of payment have to sum to zero: that’s true, but it does not mean that an increase in capital inflows magically translates into a trade deficit, without anything else changing (what John Williamson used to call the doctrine of immaculate transfer). A capital inflow produces a trade deficit by causing the exchange rate to appreciate, the price level to rise, or some other change in the real economy that affects trade flows.
Similarly, after a change in desired savings or investment something happens to make the accounting identity hold. And if interest rates are fixed, what happens is that GDP changes to make S and I equal. That’s actually the point of one of the ways multiplier analysis is often presented to freshmen.... [S]avings plus taxes equal investment plus government spending, the accounting identity that both Fama and Cochrane think vitiates fiscal policy — but it doesn’t. An increase in G doesn’t reduce I one for one, it increases GDP, which leads to higher S and T.... [Y]ou don’t have to accept this model as a picture of how the world works. But you do have to accept that it shows the fallacy of arguing that the savings-investment identity proves anything about the effectiveness of fiscal policy.
So how is it possible that distinguished professors believe otherwise? The answer, I think, is that we’re living in a Dark Age of macroeconomics. Remember, what defined the Dark Ages wasn’t the fact that they were primitive — the Bronze Age was primitive, too. What made the Dark Ages dark was the fact that so much knowledge had been lost, that so much known to the Greeks and Romans had been forgotten by the barbarian kingdoms that followed. And that’s what seems to have happened to macroeconomics in much of the economics profession. The knowledge that S=I doesn’t imply the Treasury view — the general understanding that macroeconomics is more than supply and demand plus the quantity equation — somehow got lost in much of the profession. I’m tempted to go on and say something about being overrun by barbarians in the grip of an obscurantist faith, but I guess I won’t. Oh wait, I guess I just did.
And at least some of the lurkers agree with me in email:
[H]ow spectacularly wrong they are... not in a clever or subtle way, but in a "let me put this on an Econ 1 final and ask freshmen to explain what's wrong here" sort of way.... You and I are out for a stroll, with no plans to buy anything. We walk by a barbershop, and I notice that there's no wait for a haircut. Having no money, I borrow some from you, write you an IOU, and go get my haircut, during which time no other customers have to wait. According to Cochrane, it's not merely the case that this couldn't happen in some models (models where the barber, having no customers, cuts prices -- or goes home to mow the lawn -- or models where you don't carry idle cash around), but that as a matter of accounting, this can't happen...
If I thought I had found an error (or a crucial unstated assumption that no one had noticed) in the work of Keynes, Hicks, Samuelson, Modigliani, Patinkin, Metzler, Tobin, ... who were not only spectacularly smart but also in many cases (Patinkin, Metzler, Tobin, ...) thought really hard about the asset market... my reaction would be, "I better figure out what my mistake is," not "I better tell the world about this right away"...
Milton Friedman disagreed with James Tobin about the relative effectiveness of monetary and fiscal policy in "normal" times. I agree with Friedman (and disagree with Tobin) about the relative effectiveness of monetary and fiscal policy in "normal" times. But Friedman thought Tobin was worth debating--Friedman did not have the stupids to claim that Tobin was completely wrong as a matter of "just accounting."
