Calling Milton Friedman: Economists Have Always Built Models in Which Aggregate Planned Expenditure Is Not Equal to Income Department

Robert Waldmann writes:

Have Macro economists explained any patterns during my lifetime: I am trying to read John Cochrane's comments on Paul Krugman's article on why economists got it so wrong. I tend to get upset while reading. I have managed to get through the first paragraph in which Cochrane compares Krugman to someone who denies that HIV causes AIDS and compares developments in economics to progress in the natural sciences...

I am apparently a stronger man than Robert Waldmann. I made it to paragraph 19--the one where Nick Rowe got hung up too:

Most of all, Krugman likes fiscal stimulus. In this quest, he accuses us and the rest of the economics profession of “mistaking beauty for truth.” He’s not that clear on what the “beauty” is that we all fell in love with, and why one should shun it. And for good reason. The first siren of beauty is simple logical consistency. Paul’s Keynesian economics requires that people make plans to consume more, invest more, and pay more taxes with the same income...

Andrew Leonard of Salon gets to paragraph 19 as well. But there, apropos of John Cochrane and Paul Krugman, he throws up his hands:

Krugman's critics go on the warpath: When two sides are in disagreement over such a foundational issue, it's hard to see how any amount of slash-and-burn Internet argument will ever reach resolution...

If I could summon Milton Friedman from the vasty deep to tell Andrew Leonard that John Cochrane is wrong, would that resolve the issue? It certainly should.

The context:

Cochrane's key point, aptly seized upon by Nick Rowe at Worthwhile Canadian Initiative. Cochrane's central critique of Keynesianism is summed up in one declaration.

Paul's Keynesian economics requires that people make plans to consume more, invest more, and pay more taxes with the same income.

Cochrane states this formulation as if it is an outright absurdity, and at first glance, maybe it does look crazy. But from a Keynesian point of view, Cochrane is totally misunderstanding how economies work. If people consume less, companies sell fewer goods and services, requiring them to lay off people, who in turn spend even less. This is the famous "paradox of thrift." This is exactly what we are living through right now. The total money supply doesn't change, but the economy goes into recession because that money is not circulating. The opposite also holds true. If people consume more, companies aiming to meet that demand hire more workers who then have the income to spend on more products.

It's not just from a Keynesian point of view. Robert Lucas won his Nobel Prize for investigating a class of situations--those with unanticipated nominal money and price level shocks--in which people are in the aggregate confused about what their real incomes are and so plan to spend more (or less) than their incomes turn out to be. Milton Friedman's monetary transmission mechanism rests on people, because their money holdings are elevated (or depressed), trying to spend more (or less) than their incomes. In fact, that is the root of Irving Fisher's foundational explanation of the quantity theory of money. Knut Wicksell's definition of the natural interest rate is that at which planned investment is just equal to savings--and so planned spending is equal to income--and in his model business cycles are driven by fluctuations in the market interest rate away from the natural rate that induce wedges between planned spending and income. Indeed, David Hume's "On the Balance of Trade"--the first economics article ever--contains an adjustment mechanism in response to monetary shocks that is driven by wedges between spending and income.

EVERY SINGLE COMPETENT MACROECONOMIST SINCE THE BEGINNING OF TIME--WELL, SINCE THE FIRST MACROECONOMICS PAPER EVER IN 1754, DAVEY HUME'S "ON THE BALANCE OF TRADE"--HAS MODELED SITUATIONS IN WHICH PLANNED EXPENDITURE IS DIFFERENT FROM INCOME.

And now let me summon Milton Friedman on how monetary and fiscal policy lead planned expenditures to deviate from incomes, and thus stimulate or retard the economy--with monetary policy, Friedman argues, being far the most powerful force in normal times: