Karl Smith Is Somewhat Bewildered by the State of Modern Macro

He thought that it was conventional wisdom that the economy was in big trouble and on the edge of crisis a year ago summer--and that it badly needed all kinds of stimulus (conventional monetary policy, quantitative easing, government financial guarantees, bank recapitalization, expansionary fiscal policy) last fall and winter. And he is disturbed to find out that that is not so.

Karl Smith writes:

Krugman vs. Cochrane «  Modeled Behavior: I posted Cochrane’s response to Krugman.... I tried to be as neutral in the posting as possible, but some may have interpreted as implicit support for Cochrane’s position. This is not the case. Indeed, at the time I wasn’t sure how I felt about either piece. Here are my thoughts as of now.

Krugman’s piece was, well, Krugman. A little abrasive and not particularly charitable to his adversaries, but smart and well reasoned nonetheless. Cochrane’s response, seemed to me, a bit out of scale to what Krugman wrote in the NYT Magazine.... [I]t felt like an escalation and that is unfortunate....

Beginning with Eugene Fama’s post arguing that the stimulus could not work because it violated basic adding up constraints I have been deeply puzzled. The probability that I understand macro on a deeper level than Fama or Cochrane is low. Yet, it seems to me that basic error is being made. Fama and Cochrane appear to either be assuming that prices adjust seamlessly throughout the entire economy or that increases in the demand for money do not reduce the total quantity of transactions.  Both of these seem to be naive assumptions.

However, given our premise, that it is unlikely I understand something Fama and Cochrane do not, the logical conclusion is that I am missing something about their argument. Yet, when I look at how the crisis unfolded I am struck by how well the basic model I was working with performed. In the spring of 2008, I told my graduate seminar class that if we had not already had the Great Depression that it would be starting now. Luckily I noted, we had learned many of the lessons and Ben Bernanke would not allow a general failure of the financial system if it could be avoided. In the days after Lehman’s fail, just over one year ago, I wrote a letter to my colleagues in the School of Government telling them we were walking a fine line. The money market appeared to be shutting down and there was a non-trivial chance that Western Capitalism was about to collapse. This, I felt, could almost certainly be avoided but we should not delude ourselves about the risks we faced. In October of 2008 I advised North Carolina officials that they were about to see an unprecedented drop in retail sales and that this would lead to massive losses in sales tax revenue. Credit was being cut and households who were spending more than they took in were going to have adjust rapidly. All of these things seemed to be confirmed by events and they were all based on a vulgar New Keynesian model of the economy with a special role for the financial sector. I didn’t think any of these forecasts were particularly prescient. Indeed, I thought I was simply translating the conventional wisdom. Apparently not...

So I left a comment:

Karl--

Cochrane's tone is not an escalation. He--and others--have been at this pitch for quite a while.

For example: John Cochrane: "[That spending can spur the economy] is not part of what anybody has taught graduate students since the 1960s. They are fairy tales that have been proved false. It is very comforting in times of stress to go back to the fairy tales we heard as children but it doesn’t make them less false..." Robert Lucas: "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.... [I]t's a very naked rationalization for policies that were already, you know, decided on for other reasons..." Edward Prescott: "I don't know why Obama said all economists agree on [the need for a stimulus bill]. They don't. If you go down to the third-tier schools, yes, but they're not the people advancing the science..." Eugene Fama of the University of Chicago: "Sorry, but I’m not familiar with [Hyman] Minsky’s work..." Luigi Zingales: "Keynesianism has conquered the hearts and minds of politicians and ordinary people alike because it provides a theoretical justification for irresponsible behaviour.... They tell politicians, who are addicted to spending our money, that government expenditures are good.... In medicine, such behaviour would get you expelled from the medical profession; in economics, it gives you a job in Washington..." Michele Boldrin: "It is a fantasy that the economic profession at large finds the "stimulus" and the "bank bailout" plans sensible and adequate.... Outside the administration, the convinced supporters of the plans are a small minority among academic economists working in those fields. Both plans contradict four decades of research and are designed to please special interest groups..."

It's the combination of extraordinary venom with... what by now I can only regard as extraordinary ignorance that truly frightens me.

And, yes, I think you do understand macro issues at a deeper level than Cochrane and Fama. It really does look like they think we are in an economy with a rigid cash-in-advance constraint and a technologically-determined velocity. That's the only way I can find to make any sense at all of Fama's manipulations of the savings-investment identity, and of Cochrane's claim that it is logically inconsistent for a model to have people on aggregate trying to run down their real money balances.

And, yes, these issues were settled by the time of Irving Fisher.

Now venom I could understand--these are important issues that affect lots of people's lives, and worth caring deeply about. Ignorance I could understand--the quantity theory of money is not an obvious and transparent beast. It's the combination that is scary.