The political economics of being Paul Krugman – Kantoos Economics: we don’t know much about the ideological divide and pitfalls of the US debate – and more importantly, we don’t care. I realized this three years ago, in early 2009, when I read John Cochrane’s piece on fiscal stimulus. It is a little convoluted, unfortunately, but an interesting read nonetheless. I would have loved to read a proper response by Paul or Brad DeLong, but only found unjustified rants that had little to do with John’s arguments – if you actually read the whole piece.
Brad DeLong: Time to Bang My Head Against the Wall Some More (Pre-Elementary Monetary Economics Department): Oh boy. John Cochrane does not know something that David Hume did--that the velocity of monetary circulation is an economic variable rather than a technological constant. Cochrane:
Fiscal 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”...
Let us take this slowly.
Suppose that we have four agents: Alice, Beverly, Carol, and Deborah.
Suppose that Beverly has $500 in cash that she owes Carol, due in two months. Suppose that Alice and Carol are both unemployed and idle.
In one scenario in two months Beverly goes to Carol and pays her the $500. End of story.
In a second scenario Beverly says to Alice: "I have a house. Why don't you build a deck--I will pay you $500 after the work is done. Here is the contract." Alice takes the contract and goes to Carol. She shows the contract to Carol and says: "See. I will be good for the debt. Cook me meals so I will have the strength to build the deck--here's another contract in which I promise to pay you $500 within 90 days if you cook for me." Carol agrees.
Two months pass. Carol cooks and feeds Alice. Alice goes and builds the deck.
Alice then asks Beverly for payment. Beverly says: "Wait a minute." She goes to Carol and says: "Here is the the $500 cash I owe you." Beverly pays the money to Carol. Beverly then says: "But now could I borrow the cash back by offering you a long-term mortgage at an attractive interest rate secured with an interest in my newly more-valuable house?" Carol says: "Sure." Beverly files an amended deed showing Carol's mortgage lien with the town office. Carol gives Beverly back the $500. Beverly then goes to Alice and pays her the $500. Alice then goes to Carol and pays her the $500.
The net result? (a) Alice who would otherwise have been idle has been employed--has traded her labor for meals. (b) Carol who would otherwise have been idle has been employed--has traded her labor for a secured lien on Beverly's house. (c) Beverly has taken out a mortgage on her house and in exchange has gotten a deck built. (d) Carol has the $500 cash that Beverly owed her in the first place.
Alice has more income and consumption expenditure than if she hadn't taken Beverly's job offer. Carol has more income and saving than if she hadn't cooked for Alice and then invested her earnings with Beverly. Beverly has an extra capital asset (the deck) and an extra financial liability (the mortgage) than if she had never offered to hire Alice.
A deck has gotten built. Meals have been cooked and eaten. Two women have been employed. And all this has happened without printing any extra money.
John Cochrane would say that this is impossible. John Cochrane would say:
[I]f money is not going to be printed, it has to come from somewhere. If Beverly borrows a dollar from Carol, that is a dollar that Carol does not spend, or does not lend to Deborah to spend on new investment. Every dollar of increased Beverly spending must correspond to one less dollar of Carol or Deborah spending. Alice's job created by Beverly spending is offset by a job lost from the decline in Carol or Deborah spending. We can build decks instead of fountains, but Beverly stimulus can’t help us to build more of both. This is just accounting, and does not need a complex argument about “crowding out”...
John Cochrane is wrong.
You sometimes see this mistake in freshmen students in Economics 1, students who do not fully understand either the circular flow of economic activity or what a credit economy is. They think--like Cochrane--that the flow of spending must be constant unless somebody "prints money" because, you see, you need "money" in order to buy things.
The premise is true--you do need "money" to buy things--but the conclusion is false: the flow of spending is not necessarily constant. In the world in which Beverly does not hire Alice but instead pays the $500 directly to Carol, that $500 turns over only once--its velocity of circulation is equal to one. In the world in which Beverly does hire Alice, the velocity of circulation of the $500 is four--it goes from Beverly to Carol, from Carol to Beverly, from Beverly to Alice, and from Alice to Carol.
Cochrane's mistake--an elementary, freshman mistake--is because he has not thought enough about how a credit economy works to recognize that the velocity of circulation can be an economic variable and is not necessarily a technological constant. And as the velocity of circulation varies, the amount of the flow of spending varies as well: it is now longer the case that if Beverly borrows a dollar from Carol that is a dollar that Carol does not spend.
Milton Friedman knew this. Irving Fisher knew this. Simon Newcomb knew this. David Hume knew this. John Cochrane does not know this: does not know that the velocity of circulation is an economic variable rather than a technological constant.
I do want to pound my head against the wall.
I do not know what else to do...
From my perspective, that is not an unjustified rant but a justified rant: Cochrane assumes that the velocity of circulation is a technological constant--which it is not--rather than an economic variable--which it is--and so talks nonsense, making Econ-1 level mistakes.
How am I supposed to deal with this?
Paul Krugman's response at the time was no more an "unjustified rant" than mine was. It was a rant, yes--but a highly justified one.
A Dark Age of macroeconomics (wonkish): 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.
The problem is simple: bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another.
And here’s Cochrane:
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.1 This is just accounting, and does not need a complex argument about “crowding out.”
Second, investment is “spending” every bit as much as consumption. Fiscal stimulus advocates want money spent on consumption, not saved. They evaluate past stimulus programs by whether people who got stimulus money spent it on consumption goods rather save it. But the economy overall does not care if you buy a car, or if you lend money to a company that buys a forklift.
There’s no ambiguity in either case: both Fama and Cochrane are asserting that desired savings are automatically converted into investment spending, and that any government borrowing must come at the expense of investment — period.
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.
Now, you 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.